We all know that having an ample emergency fund is important to ensure solvency should you encounter unexpected expenses. And most people know that taking money out of a 401(k) is not ideal. But what happens when financial hardship arises and an emergency fund isn’t enough? That’s where 401(k) hardship distributions can come in. Before you borrow from your retirement savings, you should understand the risks. And if you need hands-on guidance while exploring 401(k) hardship distributions, consider enlisting the help of a financial advisor in your area best suited to your needs.
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Ideally, no one would touch his or her 401(k) until retirement. In the real world, though, people draw on the money in their 401(k)s for things like mortgage payments and financial emergencies. The rules for hardship withdrawals from a 401(k) vary slightly from plan to plan, but here are the basics:
1. Only certain expenses qualify
The IRS permits hardship withdrawals in order to:
- Pay your medical bills, or those of your spouse and dependents
- Buy or retain a primary residence (i.e. avoid foreclosure or eviction)
- Cover your educational expenses or those of your spouse and dependents
- Pay for family funeral expenses
- Cover the costs of 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 distributions for medical and funeral expenses than for other types of bills. It’s easier to make a case for paying off an existing obligation than for a 401(k) hardship withdrawal for a home purchase.
2. It should be a last resort
When you take hardship distributions 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 aren’t withdrawing extra from your 401(k) to prevent foreclosure and take a Caribbean vacation.
Related Article: How to Convince Your Employer to Add 401(k) Plans
3. You can’t withdraw everything
The money that’s in your 401(k) is comprised of your contributions, the earnings on those contributions and any matching from your employer. Depending on your company’s plan, you may be able to withdraw some matched funds. You can’t withdraw earnings, though. That means what you can withdraw is up to the exact amount you contributed, not the sum of your contributions and the gains they’ve made over the years.
4. There will be tax consequences
Taking a hardship withdrawal from your 401(k) is an alternative to taking a loan from your 401(k) funds. While you won’t have to pay the money back when you take a hardship distribution, there are still tax consequences for your 401(k) early withdrawal – and a 10% penalty if you withdraw before age 59 and a half. The money you withdraw will be taxed as regular income, so it’s important to plan accordingly.
Related article: When to Leverage a 401(k) for a Home Down Payment
5. You can’t contribute again for six months
Once you take a hardship withdrawal from your 401(k), you’re not permitted to make a contribution to your 401(k) for six months. Even if your finances turn around quickly, you’ll have to wait before resuming contributions to your employer-sponsored retirement plan.
The Bottom Line
Once you resume 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) money where it is if at all possible. To ensure you don’t find yourself in this position, consider working with a financial advisor to help you come up with a financial plan and make sure you stay on track. SmartAsset’s free financial advisor matching tool makes it easier to find an advisor who suits your needs. Simply answer a series of questions about your financial situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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