Expert: Allen - 1/9/2008

Question
Allen, my wife (age 43) has decided to change from full time to part time status at work to return to school. To do so she needs to access her 401k. I have a few questions regarding 401k withdrawls. I've always heard 10% is held for tax and 10% for penalty. Fidelity told my wife the penalty is 20%. Who determines the penalty rate and who gets that money? Also, who determines if a withdrawl is considered a hardship withdrawl and could her case be considered a hardship withdrawl? Finally, a friend told my wife that money taken from a 401k for school is not taxable. I disagreed since there are other tax credits available. Do you know who is correct?  Thanks so much for your time.

Answer
You have asked several questions and I'll try to give you the general rules. However, some of the answers will require you to look at the Summary Plan Description for the plan or to contact the Plan Administrator. If you don't have a copy of the Summary Plan Description or don't know who the Plan Administrator is, go to the Human Resources Dept. for the company.

First regarding taxation. The amount that is withheld is NOT the amount you will pay in taxes. It is an amount specified by the law and is similar to withholding on your salary. Specifically, the distribution will definitely be subject to one type of taxes and may be subject to two others.

The tax that will definitely apply is federal income tax. The amount you pay will depend on your wife's and your marginal tax bracket. 20% is withheld. But you may be in a lower tax bracket or in a higher tax bracket. The actual taxes will be determined when you prepare your tax return for 2008. You may owe additional taxes or may receive a refund. When your wife receives the forms to elect a distribution there will be a detailed Tax Notice which will explain the rules.

A second tax which may apply is state income tax. This will depend on the state you live in. If there is no state income tax in your state, no tax will be due. However, in most states there is a state income tax and you will have to pay this tax. Again the amount will depend on your marginal tax rate. Some states require the trustee to withhold a portion of the distribution as an estimate of the amount that will be paid.

The third tax is a 10% federal excise tax which is paid on most distributions received before age 59 1/2. There are a few exceptions and these are described in the Tax Notice. Some of the exceptions apply to certain types of hardship distributions.

The definition of hardship depends on the terms of your wife's plan. The rules will be described in the Summary Plan Description or can be obtained by contacting the Plan Administrator.

If at all possible, consider using other sources of money such as a home equity loan before you go to the 401k.