Hardship withdrawals from your 401(k) account can be a means of dealing with a serious personal financial crisis.
What Is a Hardship Withdrawal?
A hardship withdrawal is an emergency withdrawal from a retirement plan. These may be offered in a 401(k) plan, a 403(b) or a 457 plan. Plan sponsors are not required to offer this option, rather, it’s an elective modification to the plan rules.
Hardship withdrawals, if allowed by your plan, must meet certain criteria set by the plan. Note a plan may decide that not all of these reasons will be acceptable and can pick and choose what constitutes an expense that justifies a hardship withdrawal. The IRS says that a hardship withdrawal “… must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.” The IRS considers these expenses ones that meet their criteria:
- Meeting unexpected medical expenses
- Costs relating to the purchase of your principal residence. Hardship withdrawals cannot be used for a vacation home or to purchase investment property.
- Tuition and related educational fees and expenses
- Funds needed to prevent the eviction from, or the foreclosure on, a principal residence
- Expenses for a burial or funeral
- Expenses for the repair of a principal residence that would qualify as a casualty deduction under IRC section 165.
The IRS also specifies that the plan’s hardship rules must apply objective and non-discriminatory standards in determining the amount approved to meet the employee’s needs.
Are Hardship Withdrawals Taxed?
Hardship withdrawals from a 401(k) will be subject to taxes as ordinary income. In some cases, they may be subject to a 10% penalty as well for employees who are under age 59½. Those under 59½ will avoid the 10% if:
- Their medical expenses exceed 7.5% of their adjusted gross income
- The employee is required by a court order to give the money to a child, dependent or an ex-spouse.
If the hardship withdrawal is from a Roth 401(k) account, the amount will generally be prorated between the after-tax contributions and earnings in the account. Taxes and any penalties will be assessed on the earnings portion of the withdrawal only.
Depending upon your tax bracket and whether or not the hardship withdrawal is subject to a 10% early withdrawal penalty, you might find yourself using 30% to 50% or more of the funds to cover the taxes and penalties.
Consequences of Taking a Hardship Withdrawal
After taking a hardship withdrawal you will be prohibited from contributing to your employer’s 401(k) plan for a period of six months, afterwards you may resume contributions up to the limits in place for that calendar year. Additionally, you are not allowed to repay the amount of the withdrawal back into your account in the plan. This means that the amount of the withdrawal and any reduced contributions for that year period are lost forever as part of your retirement savings. The amount taken via a hardship withdrawal also cannot be rolled over to an IRA account.
Not only are the amount of the withdrawal and the amount of lost contributions gone, but you’ve also lost out on any gains this money would have generated over time, plus the compounding of those gains.
Alternatives to a Hardship Withdrawal
Depending upon your situation and the nature of your financial need, there may be alternatives to taking a hardship withdrawal from your 401(k) plan account.
If your plan offers them, taking a loan from your 401(k) account might be a more desirable alternative than a hardship withdrawal. A loan offers participants more flexibility. With a loan:
- You can continue to contribute to the plan while the loan is outstanding.
- Loans not only can be repaid to the plan, but this is a requirement.
- Loan payments are made via payroll deduction in much the same fashion as your contributions to the plan.
- When you repay the loan, you are also paying interest on the loan. This payment is made back into your account as part of the loan payment to you are paying interest to yourself.
- If you do repay the loan in full, there are no tax implications until the money is withdrawn down the road, likely in retirement.
If you decide to go the 401(k) loan route, there are some things you should be aware of:
- If you leave your employer before fully repaying the loan, the outstanding balance could be come taxable. If you are under 59½, penalties and interest could apply. Some plans will allow you to set up a repayment plan when leaving the company that would allow you to avoid these taxes and potential penalties.
- There are typically limits on the amount that can be borrowed and the number of loans that can be outstanding. Check with your plan’s administrator to be sure you understand these rules.
If you have other assets that can be tapped to meet your financial this might be a viable and less costly alternative to consider. These might include:
- Cash in a savings or money market account. If you have any sort of untapped emergency fund this might be the time to use these funds.
- Investments in a taxable account. There might be taxes involved with selling investments held in a taxable account, but especially if these investments have gains that are eligible for long-term capital gains treatment, the tax bite could be much lower.
- Home equity line of credit. If you have one in place, this might be a good option as well. Be careful here as you want to be sure this can be repaid. Also note the tax benefits that existed prior to the current tax laws are largely gone.
Other options might include asking family or friends for help. There are, of course, serious pros and cons to this alternative that need to be considered.
In the case of medical debt, you might be able to ask the healthcare provider to set you up on a payment plan that could make the payments more affordable to you.