401(k) Penalty

Today TaxMama hears from Don of Starkville, MA wants to know, “I was told that if you were laid off from a job and withdrew your money from your 401K, you did not have to pay the 10% early withdrawal penalty only the federal and state taxes on the money.”

and

Another reader remarks, “I had also heard (no, not from a tax pro!) that if you withdraw funds to pay an IRS bill the penalty was also avoided.  I’ve looked at the instructions for Form 5329, and can’t find anything directly related, but I note that Exception 10 talks about “an IRS levy of a qualified retirement plan.”


Hi Don,

Did a tax professional tell you that? I doubt it.

There are several exceptions to the penalties. Exception number 06 does let you draw the money without penalty while you’re unemployed. BUT, only if you used the money to pay for health insurance premiums. http://www.irs.gov/pub/irs-pdf/i5329.pdf

A reader, Victor McDonald remarks, “I had also heard (no, not from a tax pro!) that if you withdraw funds to pay an IRS bill the penalty was also avoided.  I’ve looked at the instructions for Form 5329, and can’t find anything directly related, but I note that Exception 10 talks about “an IRS levy of a qualified retirement plan.”

Interesting question.

If you owe money to IRS, and YOU draw the money from your 401(k) to pay the taxes, you WILL pay the penalty. However, if IRS takes the money from your 401(k) via a levy, there is no penalty.  So, when we have clients in that situation, and there is no other choice, we instruct IRS to levy the account. That may save $1000 or more.

However, if you’re presently unemployed, and owe IRS money, there is another alternative. And this may surprise you.

Just call IRS and tell them that you are unemployed and don’t have the money to pay the taxes. They will put a hardship code on your account to put all collections actions on hold. The hold will last for six months to a year to give you time to get back in the workforce. The number is 800-829-1040.

Do it, you’ll get the pressure off.

And, remember, you’ll find answers about lots of information about tax penalties and other tax issues, free. Where? Where else? At TaxMama.com

  • Ask TaxMama :: Where taxes are fun and answers are free
  • IRSForm 5329 :: Additional Taxes on Qualified Plans (and exceptions)

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