Is it possible to take advantage of exceptions to early withdrawal penalties on a 401(k)?
As I understand, in addition to having to pay income tax on gains, early withdrawals from a 401(k) also incur a penalty. But, I also heard that there are exceptions to the penalty, e.g. if paying educational expenses. If this is true, though, then for example, why wouldn't I maximize my contribution as much as my company's willing to match, given that I could withdraw that amount immediately with no penalties? In other words, what stops me from increasing my contribution given that an exception would allow me to withdraw that increase plus a matched amount, right away?
Have I been misinformed about exceptions? Or, am I misunderstanding how matching works, e.g. does the company match only once a year in lump? (But even then, it seems possible to take advantage.) Or, am I misunderstanding how withdrawing works, e.g. is there a limit to the frequency of withdrawing? (Ditto—I still see an advantage.)
From page 34 of Publication 575:
Exceptions to tax. Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution
code “2,” “3,” or “4” should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329.
From page 3 of Publication 970:
Take early distributions from any type of individual retirement arrangement (IRA) for education costs without paying the 10% additional tax on early distributions;
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Most companies put the company match in your account each paycheck, but your are not generally vested for the match. If you leave before the specified time period then they pull back part of the matching funds.
I knew somebody who did something similar back in the 1980's with their 401K. They put in 8% of their paycheck after taxes; a 100% match was deposited; then they pulled out the employees contribution every quarter. They did this for the 10 years I knew them.
It avoided any tax implications, and they were still saving 8% of their pay for retirement.
Your question doesn't make much sense. The exceptions are very specific and are listed on this site (IRS.GOV). I can't see how you can use any of the exceptions regularly while still continuing being employed and contributing.
In any case, you pay income tax on any distribution that has not been taxed before (which would be a Roth account or a non-deductible IRA contribution). Including the employer's match.
Here's the relevant portion:
Distributions made to your beneficiary or estate on or after your death.
Distributions made because you are totally and permanently disabled.
Distributions made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies
of you and your designated beneficiary. If these distributions are
from a qualified plan other than an IRA, you must separate from
service with this employer before the payments begin for this
exception to apply.
Distributions to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income),
whether or not you itemize your deductions for the year. For more
information on medical expenses, refer to Topic 502.
Distributions made due to an IRS levy of the plan under section 6331.
Distributions that are qualified reservist distributions. Generally, these are distributions made to individuals that are called
to active duty for at least 180 days after September 11, 2001.
The following additional exceptions apply only to distributions from a
qualified retirement plan other than an IRA:
Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you
reached age 55, or distributions made from a qualified governmental
defined benefit plan if you were a qualified public safety employee
(State or local government) who separated from service on or after you
reached age 50.
Distributions made to an alternate payee under a qualified domestic relations order, and
Distributions of dividends from employee stock ownership plans.
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