How to avoid 401k withdrawal 10% tax penalty?

[danisara]

I am thinking about taking some money out of my 401k. I think that I would need to pay 10% tax penalty of I do so. Is there a way to avoid this in any way?

[sunset]

I am thinking about taking some money out of my 401k. I think that I would need to pay 10% tax penalty of I do so. Is there a way to avoid this in any way?

It depends. If you meet the definitions for disability under Sec. 72(m)(7), then perhaps you would be excluded from paying the 10% penalty...

Code:

TITLE 26 - INTERNAL REVENUE CODE
 Subtitle A - Income Taxes
  CHAPTER 1 - NORMAL TAXES AND SURTAXES
   Subchapter B - Computation of Taxable Income
    PART II - ITEMS SPECIFICALLY INCLUDED IN GROSS INCOME

     Internal Revenue Code: 
     Sec. 72. Annuities; certain proceeds of endowment and life insurance contracts

[i]"For purposes of this section , an individual shall be considered to be disabled if he is unable 
to engage in any substantial gainful activity by reason of any medically determinable physical 
or mental impairment which can be expected to result in death or to be of long-continued and 
indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof 
of the existence thereof in such form and manner as the Secretary may require."[/i]

Note, the definition of disability is more strict in this case than the definition that applies to when collecting disability. If you can meet this definition, the 10% would not apply.

(Hope you are not going to get a chain-saw now  )

[indian]

First, trying to avoid paying taxes can get you into jail.

Second, just to explain how it works..

In general, lump sum distributions are witheld 20% mandatory w/hldg s/h/b. (that is witholding that includes the 10% tax penalty)
If your withdrawal is reported on form 1099R with code 2 (disability), then no 10% penalty applies.
If your withdrawal is reported on form 1099R with code 1, the early distribution 10% penalty applies.

In this case, you can try to file form 5329 and indicate reason for claiming exception from penalty.

Disability for these purposes means, unable to engage in any substantial activity for at least a year or likely to result in death or something along those lines.