I am quitting my job to go back to school full time. I will be needing money from my 401k to pay bills and school expenses. How can I avoid the 10 percent penalty?

[DanPaul02]

A hardship withdrawal from a participant’s elective deferral account can only be made if the distribution meets two conditions.

• It's due to an immediate and heavy financial need.
• It's limited to the amount necessary to satisfy that financial need

A hardship withdrawal can be taken without a penalty. For example, taking out money to help with economic hardship, pay college tuition, or fund a down payment for a first home are all withdrawals that are not subject to penalties, though you still will have to pay income tax at your regular tax rate.

You will not pay a penalty on the withdrawal, but will pay tax on the money.  The Cares Act also gives the option of paying the taxes on the withdrawal over a three year period. 

You can withdraw up to $100,000 without a 10% early withdrawal penalty.

[TomD8]

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[Opus 17]

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@TomD8 wrote:

Another alternative is to take a loan from your 401K.  You'll generally have 5 years to repay the loan, plus interest (but the interest you pay goes back into your 401K account).  There are no taxes or penalties on a 401K loan.  Your 401K plan may have a limit on the amount you can borrow.  Drawback: if you can't repay the loan, it's considered defaulted, and in that case you'd owe both penalties and interest.

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A loan does not apply, taxpayer is quitting (separating from service.). As soon as the taxpayer quits, the loan gets converted to a distribution, and subject to tax and penalties, unless the taxpayer can repay the loan within the required time frame. 

[Opus 17]

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@DanPaul02 wrote:

A hardship withdrawal from a participant’s elective deferral account can only be made if the distribution meets two conditions.

• It's due to an immediate and heavy financial need.
• It's limited to the amount necessary to satisfy that financial need

A hardship withdrawal can be taken without a penalty. For example, taking out money to help with economic hardship, pay college tuition, or fund a down payment for a first home are all withdrawals that are not subject to penalties, though you still will have to pay income tax at your regular tax rate.

You will not pay a penalty on the withdrawal, but will pay tax on the money.  The Cares Act also gives the option of paying the taxes on the withdrawal over a three year period. 

You can withdraw up to $100,000 without a 10% early withdrawal penalty.

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Hardship withdrawals are NOT exempt from the 10% early withdrawal penalty unless the taxpayer qualifies for an exemption under the normal rules, and education is NOT an exemption for 401(k) distributions.

https://www.irs.gov/retirement-plans/401k-plan-hardship-distributions-consider-the-consequences

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distri...

Also, the CARES act provision waiving the penalty and allowing tax on withdrawals to be spread out over 3 years only applies to COVID-related hardships and that provision expired 12/31/2020, despite articles on the web to the contrary.

[Opus 17]

Sorry for the misinformation.  Here is the correct way to do it.

After separating from service, roll the 401(k) over into an IRA.  Then, take withdrawals from the IRA.  Withdrawals from an IRA to pay qualified education expenses are exempt from the 10% early withdrawal penalty.

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distri...

It is critical to understand that, although IRAs and 401(k)s have a similar purpose, they are controlled by different sections of the tax law and some of the rules are very different.  Hardship withdrawals from the 401(k) are NOT exempt from the 10% penalty, unless you qualify for another exemption, and education is NOT an exemption for 401(k) withdrawals, even though it is an exemption for IRAs.  A 401(k) loan is also not appropriate because, as soon as you quit, it will be converted to a distribution and subject to the 10% penalty.

Now, if you did take a loan from the 401(k) before quitting, you would have until April 15 of the year after you quit to repay the loan without tax and penalty.  If you only needed the money temporarily, that might be a way to manage it.  But if you don't repay the loan, it become a fully taxable distribution. 

[TomD8]

The IRS lists "tuition and related educational expenses" as a valid reason for a hardship withdrawal from a 401K, if allowed by the plan.

401k Plan Hardship Distributions Consider the Consequences | Internal Revenue Service (irs.gov)

[Opus 17]

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@TomD8 wrote:

The IRS lists "tuition and related educational expenses" as a valid reason for a hardship withdrawal from a 401K, if allowed by the plan.

401k Plan Hardship Distributions Consider the Consequences | Internal Revenue Service (irs.gov)

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Tuition is an allowable hardship to make a withdrawal, but a hardship withdrawal for tuition is not exempt from the 10% penalty for early withdrawals.

The point of a 401(k) is to leave the money until you retire.  You can't withdraw money at will, like you can with an IRA.  You can only withdraw money if you separate from service (quit, retire or are fired) or if you can prove a hardship.  (In addition, 401(k) plans are not required to allow hardship withdrawals at all, but if they do, they must follow certain rules.)

However, getting the money out is a different issue than what kind of tax you pay on the money after you withdraw it.  While there is an education exception to the penalty for IRAs, there is no education exception to the penalty for 401(k).

At your link:

However, you should know these consequences before taking a hardship distribution:

• The amount of the hardship distribution will permanently reduce the amount you’ll have in the plan at retirement.
• You must pay income tax on any previously untaxed money you receive as a hardship distribution.
• You may also have to pay an additional 10% tax, unless you're age 59½ or older or qualify for another exception.
• You may not be able to contribute to your account for six months after you receive the hardship distribution.

Check the linked list of exceptions.