Discover the Tax Deductions for 401k Losses

• 401(k) accounts are tax-deferred retirement plans.
• Contributions to 401(k) accounts are taken out of your paycheck before taxes, which lowers the income taxes that are deducted from your paycheck.
• A 401(k) account allows you to invest money in stocks, bonds, and other securities.

401(k) account owners are often subject to unexpected financial hardships, such as unemployment, illness, or divorce. These unforeseen events can result in a 401(k) account being overdrawn. When this happens, account holders may have to write a personal check or withdraw money to make proper payments, and the IRS may penalize the account holder with a tax penalty.
The good news is that 401(k) account holders can take a legitimate tax deduction to offset these losses. However, it's important to understand which losses are deductible, which losses are not, and which losses are partly deductible.

Death of an Employer/Participant

A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant.

Employer Termination
A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant, if the employer terminates the employer's plan.

Beneficiary Designation
A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant, if a participant designated a beneficiary to receive the assets upon the participant's death.

Death of Spouse or Partner
A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant, if a participant's spouse or partner dies.

Divorce
A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant, if the participant's marriage is legally dissolved.

Legal Separation
A 401(k) plan participant, spouse, former spouse, or dependent who inherits or acquires an inherited retirement account from a participant, if the participant's marriage legally ends.

Divorce

Unfortunately, there are not many tax benefits to divorce. But one benefit is for 401(k) participants, who are allowed to deduct their contributions to 401(k) plans-and spousal 401(k) contributions-from their taxes.
This means if you've contributed $10,000 to your 401(k) plan and your spouse has contributed $5,000, you can deduct $15,000 from your tax bill.
Divorced parents
Divorced parents are allowed to deduct child and dependent care expenses from their taxes, provided their children are under 13 or dependent adults.

Fire

If you're unable to buy back your shares in their company's stock, you can elect to liquidate the shares by selling them at a loss.
The bad news is, any profit your 401k account makes is ultimately taxed as ordinary income, subject to both federal and state taxes.
The good news, however, is that if your 401k account incurs a loss, you can claim a tax deduction by filing Form 1040, Schedule D. You can also deduct any losses incurred from profit-sharing plans, IRAs, and pension plans, as well as from selling a security for a loss.
Loss Limitations
You can only deduct up to $3,000 in losses from your 401k account.

Financial Hardship

If you've lost your job and need to access money in your 401k, you may be eligible for a tax-deduction. A job loss can be devastating and can easily lead to financial hardship.
However, if you lose your job and withdraw money from your 401k plan, you are generally ineligible for a tax-deduction for the withdrawal. The IRS considers a 401k loan a distribution.
The IRS does allow taxpayers, after December 31, 2009, to access their 401k plans in a financial emergency. In 2018, the IRS established a three-year financial hardship provision. This provision allows taxpayers to access up to $50,000 from their individual retirement accounts (IRAs) or 401k plans without penalty if:
They lose their job;

Their employer offers no retirement plan; or

They experience a financial hardship, including caring for a seriously ill child, spouse, or parent.
Taxpayers who do not meet the above criteria may pay a penalty of 10% on the amount they withdraw.

Retiring Early

If you plan to retire early, you can take a tax deduction for IRA losses in the same year. This is especially useful if your retirement fund is producing large losses. The losses do not count toward your annual adjusted gross income (AGI), and you can take a deduction of up to $3,000.
However, this deduction only applies if you are under 591⁄2. If you are older than 591⁄2, the loss is treated as ordinary income and can only offset up to $3,000 of your income.
There is one other limitation to this exemption. If your AGI falls below $100,000, the IRA loss deduction can be claimed only against earned income, and not investment income. If your AGI is between $100,000 and $121,500, the deduction can be claimed against both earned income and investment income.

Job Loss

If you lost your job and were unemployed for 12 weeks or more, you can make a 401k hardship distribution. You must have been employed at least 5 of the last 10 years. The distribution can't be more than $10,000, and you must repay any funds that were taken out of the 401k before the 12-week qualifying period.
Disability
If you have a disability that prevents you from working, you may be able to take a 401k hardship distribution. You must have been employed at least 5 of the last 10 years. The distribution can't be more than $10,000, and you must repay any funds that were taken out of the 401k before the 12-week qualifying period.
Medical Bills
If you or your dependents have incurred substantial medical expenses, you may be able to make a 401k hardship distribution. You can receive a 401k hardship distribution to pay medical bills for yourself, your spouse, and your dependents. The distribution can't be more than $10,000, and you must repay any funds that were taken out of the 401k before the 12-week qualifying period.
Student Loans
If you took out student loans in order to attend college, you may be able to take a 401k hardship distribution. You must have been employed at least 5 of the last 10 years. The distribution can't be more than $10,000, and you must repay any funds that were taken out of the 401k before the 12-week qualifying period.
Taxes
You can receive a 401k hardship distribution to pay your income taxes. You must have been employed at least 5 of the last 10 years. The distribution can't be more than $10,000, and you must repay any funds that were taken out of the 401k before the 12-week qualifying period.

Tax Exempt Withdrawal

If you are over 591⁄2, a 401k plan allows you to take money out without taxes or penalty, as long as these funds are used for retirement. However, if you are younger than 591⁄2, you are subject to ordinary income tax and an early withdrawal penalty.

Withdrawal Due to Involuntary Separation or Divorce

If you separate from service voluntarily, you can withdraw up to $50,000 ($60,000 if you're 50 or older) from your 401k account penalty free. The IRS doesn't count that money as income, so it won't add to your taxable income.
However, if you separate from service involuntarily (you're fired, laid off, or quit), you generally can't withdraw money from your 401k account.

Withdrawal Due to a Job Loss

In most cases, a withdrawal from a 401(k) plan can be deducted as a loss only if it was withdrawn due to a job loss. Any withdrawals from your 401(k) account that are not withdrawn due to a job loss, such as a withdrawal to fund a college education, are not tax-deductible.

Withdrawal Due to a Financial Hardship

Investors have the option of taking an early withdrawal if (1) the withdrawal is to pay medical expenses, (2) the withdrawal is to pay certain higher education expenses, (3) the withdrawal is due to a disability, or (4) the withdrawal is to pay qualified unreimbursed employee expenses.
The remaining funds can be withdrawn using the 10% early withdrawal penalty. Investors should keep in mind, however, that the early withdrawal penalties are waived when withdrawing funds to pay medical expenses.

Withdrawal Due to Death of a Participant or Beneficiary

If you die before age 591⁄2, the IRS imposes a 10% penalty on 401(k) withdrawals. The penalty does not apply if you withdraw the funds to pay off a mortgage or qualified higher education expenses.

If you die before age 701⁄2, the IRS imposes a 50% penalty on 401(k) withdrawals. The penalty does not apply if you withdraw the funds to pay off a mortgage or qualified higher education expenses.

Distributions due to Disability
If you become disabled, the IRS allows you to withdraw 401(k) funds without incurring a penalty. The disability must meet the requirements set forth in IRS Publication 575, "Individuals With Disabilities."

Withdrawal Due to Divorce

If you are divorcing your spouse, you may be able to withdraw funds from your 401k without tax consequences. However, you cannot access the funds until your divorce is finalized.
One spouse can withdraw the money and use it for a down payment on a home, pay off debt, or pay for college.
The withdrawn funds are not taxed as long as one spouse does not withdraw more than $10,000 a year.
Once a divorce is finalized, the withdrawn funds can be taxed as income.

Withdrawal Due to Retiring Early

If you are retired and withdraw money early from your account, you may be subject to early withdrawal penalties when withdrawing funds. These penalties will typically be assessed by the IRS and are based on how much you withdraw above your tax-deferred contributions.
In 2019, the IRS allowed early withdrawals of up to $200,000 from 401(k)s without penalty. If you withdraw more than $200,000, you will still be subject to ordinary income tax. However, if you withdraw more than $200,000 and roll over the money into another 401(k) account or an IRA, you will not be subject to any early withdrawal penalties.

Withdrawal Due to Unemployment

If you become unemployed, you can withdraw up to $10,000 from your 401k tax free. For 2021, this limit is $10,500. If you withdraw more than $10,500, the remaining amount is treated as a taxable distribution.
Taxes on 401k Distributions
When you withdraw money from your 401k, you will have to pay income taxes on the amount that you withdraw. Your withdrawal will be taxable based on your current income tax rate, and may be subject to an additional 10% early withdrawal penalty if you are younger than 591⁄2.

Withdrawal Due to a Change in Employment Status or Living Situation

You can withdraw funds from your 401k plan without penalty if you are no longer working for the employer that sponsors the plan. You must withdraw the funds no later than six months after you terminate employment. You may not withdraw funds if you are not currently working, but your employer is contributing amounts on your behalf to a 401k plan. In this situation, you are not required to withdraw the funds, but contributions made to the plan on your behalf over the prior year must be distributed within 60 days of termination.
In addition to the above, if you are married and your spouse dies, you can withdraw funds from your 401k plan without penalty.

Withdrawal Due to a Fire

You can withdraw money from your 401(k) plan account and get a favorable tax treatment if you are the victim of a fire, tornado, hurricane, or other natural catastrophe. In general, the 401(k) plan administrator must allow a distribution up to 100 percent of your account's balance.
The distribution you make from your 401(k) plan account is not subject to an early distribution penalty because it would be a qualified return.

Withdrawal Due to a Natural Disaster

A plan participant can withdraw funds from his or her 401(k) plan if the plan's assets have been affected by a natural disaster, such as floods, tornadoes, wildfires, hurricanes, or earthquakes.
If a plan participant is eligible to withdraw funds from his or her 401(k) plan due to a natural disaster, the participant is required to withdraw the total funds in the participant's account without penalty. The participant can generally use the funds from the account to pay for necessary expenses, such as replacing household goods, paying medical expenses, or paying rent or mortgage expenses.
The IRS classifies a natural disaster as an event such as a hurricane, tornado, flood, or wildfire that damages the participant's primary residence or any secondary home used by a participant, even if the home is owned by the participant. In addition, the IRS classifies any disruption in the participant's commute to work due to a natural disaster as a qualified disruption.

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The Bottom Line

Although the Internal Revenue Service (IRS) does not favor individual investors over corporate investors, the 401k plan is still beneficial for individual investors. If you are an early retiree, you may want to use your 401k plan as a tax shelter.