While my wife was with her former employer, she had a 401k. A few years ago before we met, she took out money from her 401 k to buy her house. Since then she has left that employer. We got hit with a 1099-R form this year from Prudential. Now, she btook out this money to buy her first home, which would make it eligible for the 1st time home buyers tax credit. But, Prudential listed on the 1099, in Box 7, the distribution code as a 1. With this code she is not able to use the tax credit. I called Prudential for my wife today, and they are telling me that this money was just a loan, that had to be paid back. They said this money was never designated to be used to buy a house. They said that the only was that the code in Box 7 would be a different number was if she took out the money as a withdrawl, and used it to buy a house. I think we are getting screwed. When she took the money out she told them that it was going to be used to purchase her first home. If they are handling her money, are financial advisors, and she gave them the info to buy the house, why are we getting screwed? Is there anything that can be done? Thank you for your help.

Her loan was reclassified as a distribution when she left her former employee. If she had repaid the loan at that time, then all would be well, but because she didn't repay it the loan became a withdrawal. So yes, this is a taxable event, and also subject to the 10% early withdrawall penalty. The code 1 in box 7 means the withdrawl is taxable. This has nothing to do with the first time home buyers credit. I don't understand why you are tieing the issue of tax on the 401(k) withdrawal to the first time home buyer's credit - please clarify.

I have a feeling you are missing something here. The first time home buyers tax credit doesn't have anything to do with the source of the funds. You can claim that credit if you purchased your first home during the eleigibility period.

I think what you are thinking of is avoiding the early withdrawal penalty when the withdrawal was used to purchase a new home. But that exemption doesn't apply to 401Ks, only to IRAs. A 401K doesn't have to permit a withdrawal, but it can permit them only in case of hardship. One of the qualification for a hardship withdrawal is purchase of a home. But that only gets the withdrawal allowed, the 10% penalty is still enforced.

Also, it appears that your wife took a loan not a withdrawal. When she left the employ of the company, that loan had to be paid back or it would be considered an inservice withdrawal which incurs a 10% penalty as well as a tax liability. Since the money was paid out in a loan, no withholding was taken to offset the tax liability.

I suspect they suggested to her to take a loan rahter than withdraw the money to avoid the penalty and taxation. That's what I would have advised. By leaving that company and not paying back the loan, she made matters worse.

The plan admins are not financial advisors. It appears either she or you or both did not understand your options or the consequences of her actions.