Dear Tax Talk,
I have not worked since 2012. I have been living off state disability insurance and regular savings. The former has already run out and the latter is about to run out. My Social Security Disability Insurance, or SSDI, case is solid but pending. I say solid because I have two doctors, both specialists, who confirm that I am permanently disabled.

I just turned 55 years old in February 2015. I need to withdraw my 401(k) funds of nearly $40,000. I understand I do not have to pay the 10 percent penalty because I am disabled. However, the company that has my money says it has to keep 20 percent because it was not previously taxed. I understand that, based on the law and if I were still working and making money. But since I have not worked in a few years and do not need to file because I have no income to report, my question is: Is there not a way, in light of these facts, to receive the full amount of my account via a hardship withdrawal? I am fully vested, by the way. Thank you!
— Deborah

Dear Deborah,
Based on the facts you have provided, the only way you will be able to avoid the 20 percent withholding on your 401(k) distribution is if the plan allows for a hardship distribution. However, please note that although you will not be subject to the 10 percent additional tax penalty, the $40,000 will be taxable to you. And contrary to your understanding, a tax return must be filed and you will be required to pay the taxes on the income accordingly.

Normally, distributions from a qualified plan are subject to income tax in the year they are distributed. These distributions are subject to the 20 percent withholding by the plan provider unless an exception is met.

Two exceptions to the 20 percent withholding rule:

  1. The distribution is paid directly to an IRA or another eligible retirement plan (a direct rollover), or
  2. The distribution is not an “eligible rollover distribution.”

Given that it appears you will not be rolling this $40,000 distribution into another eligible retirement plan, you would have to take the position that the second exception applies — that this is not an eligible rollover distribution.

An eligible rollover distribution is defined as a distribution of all or part of an employee’s balance in a qualified retirement plan, with a few exceptions provided, none of which would apply to your case, save for the hardship distribution.

Now for the tricky part: Your specific plan would have to allow hardship distributions and provide the specific criteria used to make the determination of hardship. You can see that, though possible, the IRS certainly will require extra steps on your part as well as that of your plan provider to exempt you from the otherwise mandatory 20 percent withholding on the distribution.

Thanks for the great question and all the best in taking the necessary steps to secure your financial security.

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