Do I qualify for this loophole?
January 24, 2011 11:09 PM   Subscribe

I took an early distribution on my 401(k) when I quit my job early this year. After doing some reading on the subject, I found my medical for the year is above the 7.5% threshold. Does this mean my early withdrawal penalty doesn't apply? You are not my accountant inside!

So I got a new job early in 2010. At my old work I had a 401(k) with a happy chunk of change, around $2,200. At the time money in my pocket now was worth more than money in my pocket at 59 1/2 (stupid in the long run, I know, but I can't change 11 months ago). I took the $2,200 out as an early withdrawal and all applicable taxes were taken, by the time it was said and done the $2,200 was down to around $1,300.

I was reading that a 401(k) early withdrawal penalty can be waived if (among other things) a person's medical is over 7.5% of their adjusted gross income, and got curious. I scrounged up my medical, dental, prescription, lab and insurance bills and sure enough, my year's worth of bills adds up to a little over 8% of my AGI. As for insurance premiums, I paid my own insurance out of pocket as my new job did not provide health insurance. I am not counting premiums from my old job (part of cafeteria benefits).

So: Can I legitimately get the $220 or so back for the early withdrawl penalty? Even though my real intention wasn't to pay medical bills, it was to have cash? Am I greatly increasing my chance of getting audited by doing this?

You are not my accountant, I'm looking for general thoughts. I hold no one other than Mister Fabulous responsible for his upcoming tax forms. I am in the great state of Oregon if it matters.
posted by Mister Fabulous to Work & Money (6 answers total)
You might be increasing your chances of getting audited, but they are still mighty low considering the amount. Who cares about an audit, if you are in the right?

I don't think intent matters here- if you meet the threshold, you meet the threshold. Just make sure you read all the relevant information. I have more than once been thrilled to see that I've somehow qualified for some tax thing, only to find a parenthetical or worksheet that proves me wrong.
posted by gjc at 5:04 AM on January 25, 2011

Do your taxes online with Turbo Tax. They let you complete your return for free - of course you will have to ante up to save or print it. But if the Turbo Tax wizard allows you to take advantage of the loophole, you can be fairly certain that you are in the clear doing it. If your taxes forms are already completed, we'll it's not you problem that Turbo Tax lets you use the system that way.
posted by COD at 6:13 AM on January 25, 2011

Thanks for the responses. I do use TurboTax for my taxes, and the wizard was allowing me to do it after entering the 1099-R. I was just surprised when I saw that extra cash showing up.
posted by Mister Fabulous at 8:03 AM on January 25, 2011

There are a couple of issues here.

1) Only unreimbursed medical expenses qualify. You have health insurance, so presumably some of your medical bills were reimbursed. Those reimbursed expenses can't count towards the 7.5% of MAGI limit. TurboTax doesn't know which expenses were reimbursed so it will let you enter anything.

2) Your 401(k) withdrawal had to be made as a hardship withdrawal. There is a form you can file, 5329, to say that your employer's report to the IRS that it was *not* a hardship withdrawal was in error.

3) A hardship withdrawal has to be to pay a "heavy and immediate" qualified expense. Since you withdrew before some of these expenses were incurred, if it came to audit time you'd have a heck of a time proving that. (Then again, they'd have a heck of a time proving that you weren't looking forward to medical expenses that you knew were coming up.) However, burden of proof is on you during the IRS audit and your i's aren't dotted, t's aren't crossed.

4) You generally have to have gone into debt to qualify as a hardship withdrawal. If you own assets and did not sell your assets to pay your medical expenses, you'll have to explain why.

5) Only the amount of the expenses that is *more* than 7.5% of your MAGI can be taken out of the 401(k) penalty-free. If you take even one dime more, it's an unqualified withdrawal and the penalty has to be paid on all that amount. In other words, if 7.5% of your MAGI is $500, and you have $600 of qualified expenses, you can only get at $100 penalty free. If you take $200 out of your 401(k), $100 is subject to early withdrawal penalty. If you take $600 out, $500 is subject to the penalty. And the amount you're allowed to withdraw penalty free is still subject to tax withholding.

6) The question of whether your self-paid health insurance premiums are a qualified unreimbursed expense is not always as simple as it sounds.

Bottom line: I don't know your individual situation, but my best reasonable guess is that your proposal is not allowable and would not withstand an audit. Whether doing it anyway will up your audit risk, I do not know, but it strikes me as a bad idea.
posted by Protocols of the Elders of Sockpuppetry at 10:45 PM on January 25, 2011 [1 favorite]

After looking at this:

1) My medical expenses were around 8% after reimbursements.

2) It definitely wasn't made as a hardship withdrawal, so 5329 would apply.

3) Definitely not "heavy and immediate."

4) I don't exactly have any assets, so this probably doesn't matter

5) The amount more than the 7.5% is only a couple of hundred max, so this is the one that makes me not want to bother. I should only get about $20 of the penalty back, which means my risk of getting audited goes up significantly for $20 lousy dollars. To hell with that.

6) My health insurance makes up around 60% of my medical expenses for the year.

So yeah, probably going to skip this attempt at getting more money back.
posted by Mister Fabulous at 8:47 AM on January 26, 2011

I'm really sorry to hear about your awful year, by the way. I hope 2011 is better.
posted by Protocols of the Elders of Sockpuppetry at 7:11 PM on January 26, 2011

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