If a taxpayer is in dire need, the taxpayer may choose to take a “hardship distribution” from a qualified retirement plan. However, as shown in a new case, Campana, TC Memo 2025-23, 3/19/25, this doesn’t absolve any tax liability.
Background: Generally, a 401(k) plan participant can withdraw funds upon separation from service, termination of the plan, death or disability or for a hardship reason. A hardship withdrawal is defined as a distribution made due to an “immediate and heavy financial need,” limited to the amount required to fill the need. Nevertheless, hardship withdrawals are still subject to federal income tax in the year they are paid out.
To qualify, a hardship withdrawal may be used for payment in the following situations:
- Medical expenses of an employee, the employee’s spouse, or a dependent;
- College tuition of an employee, the employee’s spouse, or a dependent;
- Expenses to purchase a principal residence for an employee (excluding mortgage payments);
- Expenses to ward off eviction or foreclosure of the employee’s principal residence;
- Burial or funeral expenses for an employee’s deceased parent, spouse, child or dependent; or
- Expenses for repairing casualty damage to an employee’s principal residence.
To discourage hardship withdrawals by younger employees, the IRS also imposes a 10% penalty tax, on top of the regular tax, if you’re under age 59½, unless a special exception applies (e.g. disability of the plan participant).
Under recent tax legislation, it’s easier for plan participants to self-certify that they qualify for a hardship distribution based on an immediate and heavy financial need. Other related provisions provide relief from the 10% tax penalty. But you still must pay the income tax on hardship distributions.
Facts of the new case: In 2021, the taxpayer and his family experienced extreme financial stress due to the COVID-19 pandemic. Eventually, he took a hardship withdrawal of $56,673 from his Fidelity Investments retirement account. At the time of the withdrawal, he was under the age of 59½.
Although the taxpayer filed a tax return for 2021 that included $37,964 of taxable income, he did not report the $56,673 retirement plan distribution. Similarly, he didn’t report the retirement distribution as being subject to the 10% tax penalty.
At trial, the taxpayer conceded that he received the interest income and retirement distributions, but contends that the IRS erroneously denied his refund claim from the 2017 tax year. He argues that this refund should be applied towards his tax liability for 2021. But the Tax Court doesn’t have any jurisdiction over the taxpayer’s 2017 return, so it dismissed the claim.
In addition, the Court upheld the 10% penalty for an early withdrawal, since the taxpayer didn’t produce any evidence supporting an exception to the penalty.
Finally, to add insult to injury, the Tax Court approved an accuracy-related penalty that the IRS tacked onto the tax liability. Despite expressing sympathy for the taxpayer’s plight, the Court said he did not prove reasonable cause for failing to report the taxable income. Thus, the taxpayer lost on all three counts.
Reminder: Retirement plan accounts are meant to be used to save for retirement. Hardship distributions should be made only as a last resort.
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Tags: Income Taxes, Payroll, tax court
