401K hardship withdrawl for purchase of principal residence

[GTS1101]

My client made a distribution from his 401k plan that was approved by his employer as a hardship withdrawal. It appears as if there is no way to avoid the 10% penalty. From what I read it seems to indicate there are situations when a 10% may not apply on a hardship withdrawal from a 401K because the wording says the 10% penalty may apply. I don't understand why the government would still penalize you if you are having a hard time financially. But why would the government do anything that makes sense.

Thanks!

GTS1101

[dyne]

There is NO hardship exclusion from the penalty. See IRS Pub 575 for the list of
exclusions.

[Koss]

Hardship Withdrawal

I agree with Dyne. The fact that the distribution qualified as a "hardship withdrawal" does not mean that it is excluded from the 10% penalty.

There is in fact an exclusion for distributions from an IRA that are used for a first-time home purchase. Unfortunately, this exclusion is not applicable to a 401(k).

Likewise, one can take an early distribution from an IRA for qualified educational expenses, and avoid the 10% penalty. But here again, the exception is not applicable to a 401(k).

I agree with GTS1101 that often the tax law has an outcome that does not make sense.

With that being said, here's what may be causing your confusion:

A "hardship withdrawal" from a 401(k) is a distribution that takes place while the person is still employed, prior to retirement age, and exceeds a certain percentage of the employee's vested balance. Normally, a distribution while you are still working (sometimes called an in-service withdrawal) is limited to a certain portion of the vested balance. However, if the employee meets certain criteria that are used to define "hardship," then the employer can approve an in-service withdrawal for a larger amount--potentially up to the entire vested balance.

The criteria that define "hardship" in this context are not part of what we think of as the federal tax law. The rules that govern whether and when you can draw funds from your 401(k), prior to retirement and without leaving the company, are buried in the ERISA law, which is a body of legislation that governs the management and operation of pension and retirement plans. It is a body of law that is aimed primarily at regulating how the employers manage the retirement plans, in order to prevent abuses, maintain the stability of the plans, and protect the employees' rights.

These rules will not be found anywhere in any tax publication that deals with the preparation of a Form 1040, because the rules don't apply to employees; they are rules that apply to the employers who manage the retirement plans.

In short: "Hardship" is defined by ERISA, and it is what allows the employer to release the funds. This definition has no relationship to the section of the Internal Revenue Code that establishes the 10% penalty, and the exceptions that apply to that penalty.

BMK