If you owe back taxes, you've likely exhausted most of your available assets. However, you might be able to use money from your 401(k) plan to get the Internal Revenue Service or a state tax department off your back. Knowing your options, as well as how much it's going to cost you in new taxes and penalties, helps you make smarter decisions.
The tax code permits 401(k) plans to grant hardship distributions from the plan to allow you to get money out before you turn 59 1/2 years old. All hardship distributions must be for immediate and heavy financial needs, which owing back taxes would likely satisfy. However, the criteria for hardship withdrawals vary by plan.
Taxes and Penalties
Even if your plan allows a hardship distribution for back taxes, this won't necessarily get you out of paying an early withdrawal penalty. Generally, a hardship distribution is not only taxable but also subject to an extra 10 percent early withdrawal penalty. For example, if you are in the 15 percent tax bracket and take a $1,000 withdrawal, you'll pay $150 in taxes and $100 in penalties. However, you can avoid the extra penalty if you qualify for an exception.
If your tax woes don't qualify you for a hardship withdrawal, another option may be to take out a loan for the amount you owe. This will be at the discretion of your employer. Employers are not required to allow loans on the plans they set up for their employees. You'll be required to pay the money back with interest, but the interest you pay will go back into the account.
Exception for Levies
The IRS does include an exception to the 10 percent additional tax penalty if the distribution is made because of an IRS levy on the plan. The levy must be on the specific 401(k) plan; it cannot be a general levy on your assets. For example, maybe you owe $5,000 in back taxes and your car is levied upon by the IRS. If you take $5,000 from your 401(k) plan, you don't qualify for the exception.
When you take a hardship withdrawal from a 401(k) plan, you've got to tell Uncle Sam when you file your taxes. On Form 1040, you have to report the distribution as a taxable pension distribution. In addition, you have to use Form 5329 to calculate the penalty or report the exemption. If you don't have an exemption, you calculate the 10 percent penalty on the form. If you qualify for an exemption, you report the exemption code next to line 2. For IRS levies on a 401(k) plan, enter the code "10."
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."