A 401k plan offers a tax-advantaged way to defer income for retirement. Employees contribute to a 401k plan via salary deferral. Employers may also contribute to the employee's 401k via a matching contribution or profit-sharing contribution. However, withdrawals from a 401k plan are restricted by both IRS rules and the rules of each individual 401k plan.
401k Plan Fundamentals
A 401k plan is defined-contribution retirement plan sponsored by an employer. Contributions from employees are pretax, meaning that contributions are not counted as income and are tax-free. However, withdrawals from a 401k plan are considered income and subject to ordinary income taxes. Employees under age 59 1/2 withdrawing funds from a 401k may also be subject to an additional 10 percent tax penalty on the amount of the withdrawal.
401k Disability Withdrawals
Withdrawing money from a 401k plan is not allowed unless the employee has separated from service with the employer. There is an exception for employees who become disabled. Employees who are disabled may make withdrawals of both earnings and contributions from the 401k plan. All distributions are considered income and are taxable. However, distributions due to disability are not subject to the 10 percent penalty for account owners under age 59 1/2.
The Internal Revenue Code says that a person is deemed disabled if he is "unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expect to result in death or to be of long-continued and indefinite duration." By law, this standard applies to all salary deferral contributions made by the employee. The plan may use a different standard for employer contributions.
401k Hardship Distributions
If the plan allows, employees with a qualifying hardship may withdraw from the plan without separating from service. Hardship withdrawals are limited to amount of employee contributions only. Funds required for medical care may be withdrawn under this exception, if the employee's condition does not satisfy the conditions to be considered disabled. Hardship distributions are both taxable and subject to the 10 percent penalty if the account owner is under age 59 1/2.