A 401(k) hardship withdrawal is the action of taking money out of your workplace retirement plan early to deal with a life event that requires some money. A 401(k) is an employer-sponsored, tax-deferred retirement savings account. Contributing money to your 401(k) reduces your taxable income – effectively giving you an instant tax deduction. You can’t take money from your account until you reach age 59.5 — unless you need it for a specific event, in which case, a 401(k) hardship withdrawal, or hardship distribution, could help you get around some IRS penalties. These withdrawals are subject to strict conditions, however, and there are still some tax implications.
If you’re thinking of taking a hardship distribution, or just want help putting together a retirement plan, consider finding a financial advisor.
401(k) Hardship Withdrawal Eligibility
The IRS permits hardship withdrawals for the following reasons:
- Pay certain medical bills for you, your spouse or your dependents
- Avoid foreclosure on or buy a primary residence
- Cover educational expenses for you, your spouse or your dependents
- Pay for family funeral expenses
- Pay for certain kinds of home repairs, such as those necessary after a natural disaster
Some employers’ plans limit qualifying hardships further. In general, you’ll have an easier time qualifying for hardship withdrawals for medical and funeral expenses than for other types of bills. It’s easier to make a case for a 401(k) hardship withdrawal to pay off an existing obligation than it is for a new home purchase.
When you take hardship withdrawals from your 401(k), you’ll need to prove to the IRS that you don’t have other resources at your disposal, and that you’re not taking more than you need. In other words, you cannot utilize this tax workaround if you want to take a vacation to the Caribbean.
Even if you meet the requirements for a hardship withdrawal, make sure it’s definitely the right decision for you. They come with real consequences, so make them your absolute last resort.
401(k) Hardship Withdrawal Limits
The money that’s in your 401(k) is comprised of your contributions, the investment earnings on them and any matching contributions from your employer. The IRS divides your overall 401(k) account balance into these three categories.
The cap on what you’re allowed to withdraw is the amount that you’ve contributed yourself. Depending on your company’s specific 401(k) plan, you may be able to withdraw some matched funds too. However, you cannot withdraw earnings on your money.
401(k) Hardship Withdrawals Disadvantages
Making the move on a 401(k) hardship withdrawal can set your retirement savings back a bit. In fact, once you take a hardship withdrawal from your 401(k), you cannot contribute to the account for six months. So even if your finances turn around quickly, you’ll have to wait before resuming contributions to your employer-sponsored retirement plan.
Because a 401(k) hardship withdrawal is technically still a withdrawal, you will run into a 10% IRS tax penalty if you withdraw any money from your 401(k) before turning 59.5 years old. Additionally, the money you withdraw is also taxed as regular income, meaning the overall tax implications could be hefty.
401(k) Hardship Withdrawals vs. 401(k) Loans
Taking a hardship withdrawal from your 401(k) is an alternative to taking a 401(k) loan. While you won’t have to pay the money back when you take a hardship withdrawal, the aforementioned 10% IRS tax penalty will apply. Remember that this is in addition to your standard income tax rate, meaning the IRS will hit you hard come tax time.
The flip side is that a 401(k) loan is just that: a loan. Just like any other form of debt, you’ll need to pay it back, in this case, to your own account. Failure to make on-time payments will result in not only a default, but a 10% withdrawal penalty as well. That’s because the IRS will consequently view your loan as income if you don’t pay it back. Should this happen, you’ll essentially incur the disadvantages of both hardship withdrawals and 401(k) loans.
Eligibility for a hardship withdrawal is dependent upon whether or not you meet the requirements above. On the other hand, your purpose for needing a 401(k) loan is completely irrelevant in the eyes of the IRS. So as long as you can pay the money back on time, you won’t run into trouble.
If you’re looking into hardship withdrawals, chances are you’re in dire need of some extra money. However, once you finally resume making contributions, you’ll realize how tough it is to make up for lost time. That’s why it’s a good idea to leave your 401(k) alone if at all possible. To ensure that you’re proceeding with the decision best suited for your financial future, it’s a good idea to consult with a financial advisor.
Retirement Planning Tips
- Although a viable option, 401(k) hardship withdrawals aren’t ideal. A financial advisor may be able to put together a financial plan that doesn’t involve dipping into your hard-earned retirement money. SmartAsset’s free advisor matching tool can set you up with as many as three suitable advisors in your area. If you’re ready to start working with an advisor, get started now.
- Social Security can be a valuable supplement to your existing retirement funds. If you’re unsure about how much money you’re in line to receive, check out SmartAsset’s Social Security calculator. All you need to know is your annual income and the age at which you’re planning to start receiving benefits.
- If you want to handle your retirement plans on your own, make sure you’re not flying blind. SmartAsset’s retirement calculator can help you estimate how much you’ll need to save for your desired retirement lifestyle.
Photo credit: ©iStock.com/nevarpp, ©iStock.com/cyano66, ©iStock.com/fizkes