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I'm helping my SO plan for the worst since being laid off from work two weeks ago. The unemployment office's (Illinois) documentation has lots of convoluted language that among other things seems to indicate that 401(k) withdrawals qualify as wages and as such, would negate eligibility for unemployment benefits.

Dipping into the retirement fund is the absolute last resort and we both know that it comes with a 10% penalty and is taxable, but what I can't find a straight answer on is what happens if the 401k is withdrawn while receiving unemployment benefits. The maximum benefit from unemployment doesn't come close to covering expenses and it sounds like our options are either suffer or burn through the entire retirement account, then file for unemployment.

EDIT: Possibly important realization that the employer did not match any funds, so all contributions are my SO's own. From advice and anecdotes I gather it seems like converting to an IRA is the first step in reducing confusion.

  • Does the 401(k) plan allow for hardship withdrawals? Plans aren't required to offer this, but some might. Some plans allow plan loans, which may have lower penalties. – John Bensin Aug 25 '13 at 0:21
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    My state system asked if there is any "earned" income each week. A withdrawal from a retirement account is not earned income. – JoeTaxpayer Aug 25 '13 at 0:43
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    Get a job delivering pizzas or mowing lawns before dipping into a 401K. – Pete B. Aug 25 '13 at 9:41
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Here's the relevant law:

I looked at the PDF linked here -> Illinois Unemployment

On page G-46 there's language about Disqualifying Income. It describes "the entire amount of retirement pay from a former employer who has paid all the cost of such retirement pay." It then makes references to section 239, 402, and 56 in the Illinois Administrative Code.

It then goes on to say: To be disqualifying income, the retirement pay must be paid by an individual or corporation for which the individual provided services in his base period, ...

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    the base period is the period you were employed. – mhoran_psprep Aug 26 '13 at 15:55
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It might make a difference which state you live in. The matching funds from the employer when withdrawn from the account can be considered by some states as collecting income that was deferred. A big lump sum could knock you out of collecting employment for months.

To fully understand the issue you should get professional advice.

I found anecdotal stories in the news about this issue, and an 800 page pdf from Illinois, that just left me confused.

It also appears that it depends on the type of retirement account involved. IRA seemed OK, 401K was not. Union funded retirement was different.

Some people get tripped up because they have a small 401K and the old company forces them to cash it in. They don't ask for a direct transfer to an IRA so they get the check. The old company then tells the state, and they find themselves having to skip a unemployment check or two, plus pay taxes and penalties to the IRS because the lack of unemployment pay forced them to spend the money they wanted to roll over.

It appears that 401k direct to IRA is not income. It also appears that spending IRA money doesn't make you ineligible. It wasn't clear that 401K to IRA launders the source of the income so that if you spend it the state doesn't care. Thus the advice see an professional with an expertise in your state. You might need to see them twice. Once to understand what will not will not hurt you. And then again just before you spend the 401K money to make sure the law hasn't changed. Unemployment programs are a mix of state and federal rules, which just adds to the complexity.

  • Any link to the lare PDF? If there's a distinction between 401(k) and IRA, it seems a rollover to the IRA can avoid a potential issue. Interesting how this is state-specific, my state even ignores a lump sum severance payment. They don't consider it 'earned' income. – JoeTaxpayer Aug 25 '13 at 14:32
  • Yes, that 800 page PDF is largely the source of confusion. I found out actually in this case the employer doesn't contribute anything. So if it's converted to an IRA, can early withdrawals be taken without counting as 'earned' income? – Nathan Witt Aug 25 '13 at 14:47

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