If you have a 401(k) plan, you likely know that you can't simply withdraw money from it any time you'd like. In many cases, if you aren't at retirement age, you cannot make a withdrawal until your job ends. One exception that some 401(k) plans allow for is known as the "hardship withdrawal."
To find out whether your plan allows for a 401(k) hardship withdrawal, talk to your plan administrator. That might be someone in the human resources department. You can also call the phone number on your 401(k) plan account statement.
However, before starting the process of making a hardship withdrawal, you must know exactly what it entails. Learn the drawbacks before you decide.
What Are the Hardship Criteria?
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 main 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 main 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. You may be able to avoid the 10% penalty if you meet one of several exceptions:
- 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 another dependent.
What if you don't qualify for an exception to the penalty? In that case, 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 net $700 after taxes.
Do you have other resources, such as an emergency fund, that can be used to meet your needs? If so, then it is best to use those assets first. Use a 401(k) hardship withdrawal only if it is your last option.
Proof of Hardship
To qualify as a hardship, you will need to make your case to your 401(k) plan administrator. Most of the time, they can easily figure out wherther your circumstances qualify as a hardship. 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 shielded from creditors and protected from bankruptcy. If you are experiencing financial hardship and think that you may end up filing bankruptcy, do not cash out your 401(k) plan. Your creditors 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. Try working out a payment plan before you touch your 401(k) 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 pause has been eliminated, effective January 1, 2020. You are not allowed to pay back the amount of the hardship withdrawal, but, you can continue to contribute up to the maximum 401(k) allowable contribution limit for the year.
Can You Take a Hardship Withdrawal From an IRA?
The IRS does not allow hardship withdrawals from IRAs—at least, not as such. As an IRA owner, you can withdraw money at any time, but you will owe a 10% penalty if you are not yet age 59 1/2. There is an exception to this rule: You may take out money from your IRA for certain educational expenses or to buy your first home.
401(k) Hardship Withdrawal vs. 401(k) Loan
When you borrow money from your 401(k) plan, you can pay it back over five years. 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. It 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
A hardship is just that—a hardship. It won't be something you planned. Often, it will be an emergency or dire situation, and you may be out of options, but 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. Taking out money from your savings before retirement might solve your current issue, but it might create or add to a future problem that could be even harder to solve.
Before making a hardship withdrawal, talk to a financial planner, and explore all of your other options first.
Frequently Asked Questions (FAQs)
What are the consequences of taking a hardship withdrawal?
It used to be that after a hardship withdrawal, your employer could prevent you from making any contributions to that account or another. That is no longer allowed, however, since January 1st, 2020. Withdrawals from a 401(k) are subject to taxes and are included in gross income, resulting in more taxes paid when you file next. In addition, the money isn't paid back as it would be with a loan, so you are permanently down that amount from your retirement savings if you withdraw early.
What is the difference between a hardship withdrawal and a 401(k) loan?
Hardship withdrawals are allowed when there is an immediate, pressing need. The amount on these withdrawals is dependent on how much you need for the financial situation, and the IRS will tax them. 401(k) loans are better for cases where the financial need is not dire. You'll be able to borrow half of whatever is in your account, but you will be required to pay it back.