The Internal Revenue Service may grab the money you owe directly from your 401(k) -- this is called an IRS tax levy. If you already have access to your 401(k) funds, you can certainly use the money to help pay your IRS debt. Even if you don't qualify for 401(k) access via the regular rules, your plan might allow hardship distributions because of heavy and immediate financial need, possibly allowing you to drain your 401(k) to pay the IRS.
Access to Your 401(k)
Normally, you can't access your 401(k) money unless you experience certain qualifying events, including reaching age 59 1/2, leaving your job, becoming disabled, going from reservist to active-duty status, sustaining high medical bills, or receiving a court order to pay alimony or child support. You'll have to include the distributions in your taxable income and may have to pay a 10 percent early-withdrawal penalty. IRS tax levies don't incur a penalty but do count as taxable income.
If you don't experience a qualifying event, you can apply to your employer for a hardship distribution from your 401(k). Employers must have written policies that explain under what conditions they will approve hardship distributions. Therefore, the decision to allow you to cash out your 401(k) to pay the IRS is your employer's.
Equal Periodic Payments
One alternative way to access your 401(k) penalty-free is to take substantially equal periodic payments, which are tied to your age and expected life span. You can receive these payments monthly, quarterly or annually. This alternative is available only if you've separated from your job. Normally, distributions following separation trigger the 10 percent penalty unless you've reached age 55 or roll the money tax-free into another employer plan or individual retirement account. You can use equal periodic payments as you please, including paying back taxes.
Borrowing From Your 401(k)
Another alternative method to tap your 401(k) to pay back taxes is to borrow from it. A 401(k) loan does not generate taxes or penalties as long as you repay it within five years, making equal repayments at least quarterly. You must fork over interest on the unpaid balance, but you get to keep the interest payments. You can borrow up to $50,000, but no more than half of the 401(k)'s value, which must exceed $10,000. The other advantage of a 401(k) loan is that you get to replace the money, something you can't do with withdrawals. You lose the benefit of tax-free growth on the money you take out of a 401(k), which can have a negative impact on your retirement savings.