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I have a small 401k account from an employer I left a year ago. I would like to close the account and cash it out to simplify my financial profile as well as use the money for some home improvements. I saw on their web site that there is an option of Hardship Withdrawal, which has primary residence repairs option listed as a reason to choose from, among others.

Assuming I had a nominal $1000 in the account, what kind of penalties or early withdrawals can I expect upon tax filing for the year in which I withdraw and close the account?

The form also has an option to opt out of withdrawing 10% default federal tax. Considering that I will be paying taxes for this eventually upon filing taxes, are there any reasons not to opt out of paying taxes upon the withdrawal and pay it six months later when I do my taxes because paying it now vs. in the future means loaning money to the federal government at no interest? IOW, if I would eventually have to pay, say $200 of tax, I would rather pay $200 on 4/15/2016 rather than 10% now ($100) and then another $100 remaining balance later at tax time. Unless there are good reasons to pay the 10% now.

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The IRS has a FAQ page about Hardship Distributions from a 401(k).

The IRS defines a hardship in this case as "an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need." Included in the list of examples is "certain expenses for the repair of damage to the employee's principal residence." However, whether your former employer allows this particular reason is up to their plan documents. It sounds like, from what you described on the website, that your plan does include this reason as a possibility for you.

Next, you need to decide if the projects you have in mind qualify as "repair of damage." This uses the same rules as the deductible casualty rules found in IRS Publication 547, which defines a casualty this way:

A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.

  • A sudden event is one that is swift, not gradual or progressive.

  • An unexpected event is one that is ordinarily unanticipated and unintended.

  • An unusual event is one that is not a day-to-day occurrence and that is not typical of the activity in which you were engaged.

Examples are given in Pub 547. If the projects you have in mind are necessary due to an event (like a flood or a fire), it might be allowed. But most "home improvement" projects would not qualify for this.

If you'd like a way to simplify your financial profile, an option for you, since you no longer work at this employer, is to roll over this 401(k) into a Rollover (traditional) IRA. This way, you won't have to deal with your former employer anymore. You could pick an IRA custodian that you already have another account with, if you like, and reduce the number of statements that you get. But the IRA will not let you take money out without penalty for home improvement projects, either.

  • it is rolled over to an IRS with my present employer but I am not contributing to it so I would just like to close it and cash out for now. will i be scrutinized by the IRS to prove the hardship ? – amphibient Aug 11 '15 at 18:14
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    @amphibient Like most things related to income taxes in the U.S., you generally don't have to prove it unless you get audited. And the penalties for failing an audit can be severe. – Ben Miller - Reinstate Monica Aug 11 '15 at 18:20
  • i don't think i would have problem proving it, it would just be an administrative PITA that i would rather avoid if any way possible – amphibient Aug 11 '15 at 18:32
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You should call your plan administrator and ask. Few plans allow people to take a "hardship withdraw" after leaving because their is no way to pay the funds back since you are no longer working there. The repayment process is done via payroll deduction usually. Also you will most likely be required to withhold 20% for taxes from the 401k.

There is no way to defer the taxation unless you take it next calendar year. You may want to consider doing a rollover into an IRA and taking the w/d and you can do a 60 day rollover. You only get 1 per rolling 12 months now (rather than account do to a change in the rule.)

IRA's (not 401k) do give you flexible withholding so you don't have to pay taxes today though they would still be in the tax year based on the calendar date taken out, so if you take it out in 2015 your going to be paying them at the end of this year when you file in April of 2016.

Your question seems to be mixing characteristics of both 401k and IRA and while they are similar they do operate very differently.

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