Taking Early Withdrawals

• The only ways that the IRS permits you to access money in your 401(k) plan before turning 59 1/2 years old are if you leave the company or if you have a severe financial hardship. Not all 401(k) plans allow early distributions in the case of financial hardships, and some plans limit what qualifies as a hardship. Even if your plan does allow early distributions for financial hardships, the amount that you can take out is limited to the amount needed to cover the hardship, plus any applicable taxes and penalties.
  
  

Taxes and Penalties

• Your 401(k) plan is a tax-deferred retirement plan, which means that all distributions from the plan -- qualified or not -- are subject to income taxes. The IRS does not make any exceptions to this rule. When you take money out before age 59 1/2, the distribution is also subject to a 10 percent early withdrawal penalty, designed to discourage people from using money in their plans for expenses other than retirement. In limited circumstances, the IRS will waive this penalty.
  
  

Examples of Waivers

• The list of exceptions to the early withdrawal penalty is very short and a mere financial hardship does not automatically qualify. If you are at least 55 years old when you leave your company, you can take withdrawals without paying the 10 percent penalty. The IRS also does not charge the penalty when you use the money for medical expenses exceeding 7.5 percent of your adjusted gross income or because you suffer a permanent disability. Finally, if a court orders you to take a distribution to split with a former spouse in a divorce, the penalty does not apply.
  
  

Reporting the Exceptions

• When you take an early withdrawal from your 401(k) plan, you usually use Form 5329 to calculate your early distribution penalty. However, when an exception applies, you use the same form to show why you are not paying the penalty. You can use an exception even if it does not cover your entire distribution. To the left of line 2 of Form 5329, enter the code for your exception. The IRS lists these codes in the instructions for Form 5329. For example, if you are at least 55 when you leave the company, you write "01."