What to Know Before Taking a 401(k) Hardship Withdrawal
Consider the Options Before Taking a 401(k) Hardship Withdrawal
If you have a 401(k) plan, you probably already know that you can't simply withdraw money from it whenever you'd like. In many cases, if you aren't at retirement age, you cannot make a withdrawal until your employment ends. One exception that some 401(k) plans allow for is known as the hardship withdrawal.
To find out if your plan allows for a 401(k) hardship withdrawal, talk to your plan administrator. This might be someone in the human resources or benefits department. You can also call the phone number on your 401(k) plan account statement.
However, before beginning the process of making a hardship withdrawal, you must understand exactly what it entails—including the drawbacks.
If your 401(k) plan allows for hardship withdrawals, it would be for one of the seven reasons below:
- Certain medical expenses
- Costs relating to the purchase of a principal residence (in other words, you can't make a hardship withdrawal to buy an investment property or vacation home)
- Tuition and related educational fees and expenses
- Payments necessary to prevent eviction from, or foreclosure on, your principal residence
- Burial or funeral expenses
- Expenses for the repair of damage to your home
- Expenses, including loss of income, incurred if you reside in a FEMA-designated disaster area.
Taxes Affecting a 401(k) Hardship Withdrawal
You will pay taxes on the amount you take out in the form of a hardship withdrawal. In addition to regular income taxes, you will likely pay a 10% penalty tax. You may be able to avoid the 10% penalty tax if you meet one of several exceptions, including:
- You are disabled
- Your medical debt exceeds 7.5% (or 10% after 2012 if under age 65) of your adjusted gross income
- You are required by court order to give the money to your divorced spouse, a child, or a dependent
If you don't qualify for an exception to the penalty tax, you need to plan that at least $0.30 of every $1 you withdraw will go toward taxes. If you withdraw $1,000, for instance, you might only get $700 after taxes.
If you have other resources, such as an emergency fund, that can be used to meet your financial needs, then it is best to use those assets first. Use a 401(k) hardship withdrawal only if it is your last available option.
Proof of Hardship
To qualify as a hardship, you will need to explain your situation to your 401(k) plan administrator. Most of the time, they can easily determine if your circumstances qualify as a hardship, but some 401(k) plans may require you to present some form of documentation. Ask your 401(k) plan provider what they require as proof of hardship.
Before Taking a Hardship Withdrawal
Many people do not know that 401(k) money is protected from creditors and protected from bankruptcy. If you are experiencing financial hardship and think you may end up filing bankruptcy, do not cash out your 401(k) plan. Your creditors and the bankruptcy court cannot take your 401(k) plan money.
It may be better to borrow money, rather than take a 401(k) hardship withdrawal. Too many people cash out of a 401(k) plan or take a hardship withdrawal to pay medical expenses when their 401(k) money would be protected from these creditors. Try working out a payment plan with a creditor before you touch your retirement plan money.
After You Take a 401(k) Hardship Withdrawal
Under prior law, for six months after you took a 401(k) hardship withdrawal, you were not allowed to make contributions to your 401(k) plan. That six-month suspension has been eliminated, effective January 1, 2020. (Certain optional rules apply for the two preceding years.) You are not allowed to pay back the amount of the hardship withdrawal, but you can continue to contribute up the maximum 401(k) allowable contribution limit for the year.
401(k) Hardship Withdrawal or 401(k) Loan?
When you borrow money from your 401(k) plan, you can pay it back over five years, and the interest you pay goes back into your account. At the time you take a 401(k) plan loan, you will not pay taxes on the amount you borrow if the loan meets certain criteria.
If you do not pay back the full amount you borrowed according to the repayment plan, then any remaining loan amount will become a taxable distribution to you and may also be subject to a 10% early withdrawal penalty tax (if you are not yet age 59 1/2).
Because of these differences, a 401(k) plan loan allows more flexibility than a 401(k) plan hardship withdrawal.
Avoid Hardship Withdrawals If You Can
Hardships are just that—a hardship. This won't be something you planned. Often, this will be an emergency or dire situation, and you may be out of options.
However, if other options remain, exhaust those first. Many Americans are behind on retirement savings and risk severe financial shortfalls when they can no longer work. Withdrawing money from your retirement savings before retirement might solve your current issue, but it potentially creates or adds to a future problem that could be even more difficult to solve.
Before making a hardship withdrawal, talk to a financial planner or a similar expert in the area and explore all of your other options first.
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