As you may already know, you must meet certain requirements, outlined in the 401(k) plan document, to be considered eligible to receive a distribution from the plan. Your employer or plan administrator will provide you with a list of the requirements.
Amounts withdrawn from your 401(k) plan and used towards the purchase of your home will be subject to income tax and a 10% early-distribution penalty. This applies even though the distribution will be used towards the purchase of your first home, because the first-time homebuyer exception does not apply to distributions from qualified plans such as 401(k) plans. Furthermore, if the amount you receive is rollover eligible, your employer is required by law to withhold 20% for federal tax, unless the amount is rolled directly to an IRA or other eligible retirement plan. Your employer must tell you whether the amount is rollover eligible.
Assuming you are eligible to receive the distribution and the amount is rollover eligible, you may instruct the 401(k) plan to process your distribution as a direct rollover to an IRA. This will ensure that the 20% federal tax withholding is not applied to the amount. Additionally, you can then withdraw the amount from your IRA for use towards the purchase of your first home, thereby avoiding the 10% early-distribution penalty. Remember, the maximum amount that may be distributed from the IRA on a penalty-free basis for the purpose of buying a first home is $10,000. This is a lifetime limit.
If you are under age 59 ½ when the distribution occurs, your IRA custodian may report the distribution as being eligible for an exception to the 10% penalty. This is indicated with a code '2' in <?xml:namespace prefix = st1 /?>box 7 of Form 1099-R. If the custodian does not make this indication, you may file IRS Form 5329 to claim the exception.
This question was answered by Denise Appleby