A hardship withdrawal is the removal of funds from your 401(k) in response to a pressing and significant financial need. For people who find themselves in a financial bind where they need a large sum of money but don’t expect to be able to pay it back, a 401(k) hardship withdrawal may be an appropriate option. But before making a withdrawal from a 401(k) retirement account, it’s important to understand the rules and potential drawbacks of this financial decision.
Who Is Eligible for a Hardship Withdrawal?
According to the IRS, an individual can make a hardship withdrawal if they have an “immediate and heavy financial need.” However, not all 401(k) plans offer hardship withdrawals, so if you’re considering this option talk to your plan administrator—usually someone in an employer’s human resources or benefits department.
Another way to get clarity on a particular 401(k) account is to call the number on a recent 401(k) statement and ask for help.
If a retirement plan does allow hardship withdrawals, typically you’ll be expected to present your case to your plan administrator, who will decide if it meets the criteria for hardship. If it does, the amount you are able to withdraw will be limited to the amount necessary to cover your immediate financial need.
In general, a hardship withdrawal should be considered a last resort. To qualify, a person must not have any other way to cover their immediate need, such as reimbursement through insurance, by liquidating assets, taking out a commercial loan, or stopping contributions to their retirement plan and redirecting the money.
What Qualifies as a Hardship?
You may be qualified for a hardship withdrawal if you need cash to meet one of the following conditions:
• Medical care expenses for you, your spouse, or your dependents.
• Costs related to the purchase of a primary residence, excluding mortgage payments. Buying a second home or an investment property is not a valid reason for withdrawal.
• Tuition and other related expenses, including educational fees and room and board for the next 12 months of postsecondary education. This rule applies to the individual, their spouse, and their children and other dependents.
• Payments needed to prevent eviction from a primary residence, or foreclosure on the mortgage of a primary residence.
• Certain expenses to repair damage to a principal residence.
• Funeral and burial expenses.
• Some people who sustain damage to their property or suffer a loss of income due to natural disasters may be able to make emergency withdrawals.
How Do You Prove Hardship?
A 401(k) provider may need to see proof of hardship before they can determine eligibility for a hardship withdrawal.
Typically, they do not need to take a look at financial status and will accept a written statement representing your financial need. That said, an employer cannot rely on an employee’s representation of their need if the employer knows for a fact that the employee has other resources at their disposal that can cover the need. In this case, the employer may deny the hardship withdrawal.
It’s important to note that employees do not have to use alternative sources if doing so would increase the amount of their financial need. For example, say an employee is buying a primary residence. They do not need to take on loans if doing so would hinder their ability to acquire other financing necessary to purchase the house.
How Much Can You Withdraw?
The amount a person can withdraw from their 401(k) due to financial hardship is limited to the amount that is necessary to cover the immediate financial need. The total can include money to cover the taxes and any penalties on the withdrawal.
In the past, hardship distributions were limited by the amount of elective deferrals that employees had contributed to their 401(k). In other words, employees couldn’t withdraw money that had come from their employer, and they couldn’t withdraw earnings.
However, under recent reforms, employers may allow employees to withdraw elective deferrals, employer contributions and earnings. Employers are not required to follow these rules, so it’s important to ask your provider which money in your 401(k) you can draw on.
What Are the Penalties of 401(k) Hardship Withdrawals?
Taking a hardship withdrawal can be a costly endeavor. You will owe income tax on the amount you withdraw, unless you are withdrawing Roth contributions.
Since you’re in your working years, your income tax bill may be considerably more than you would pay if you were to withdraw the same money after you retire. In addition, anyone under the age of 59 ½ will also likely pay a 10 percent early withdrawal penalty.
The IRS provides a list of criteria that can exempt you from the 10 percent penalty, including if you are disabled or if you’re younger than 65 and the amount of your unreimbursed medical debt exceeds 10 percent of your adjusted gross income.
It’s important to know that a hardship withdrawal cannot be repaid to the plan. That means that whatever money you remove from your retirement account online is gone forever—no longer earning returns or subject to the benefits of tax-advantaged growth. The withdrawn amount will not be available to you in your retirement years.
Should You Consider a 401(k) Loan Instead?
Borrowing from your 401(k) may be an alternative to a hardship withdrawal. The IRS limits the amount that an individual can borrow to 50 percent of their vested account balance or $50,000, whichever is less.
However, if your vested account balance is less than $10,000, you may borrow up to that amount. There’s a reason for this: Your vested balance is the amount of money that already belongs to you. Some employers require you to stay with them for a set period of time before making their contributions available to you.
A person typically has five years to repay a 401(k) loan and usually must make payments each quarter through a payroll deduction. If repayments are not made quarterly, the remaining balance may be treated as a distribution, subject to income tax and a 10 percent early-withdrawal penalty.
While you do have to pay interest on a 401(k) loan, the good news is you pay it to yourself.
There are some drawbacks to taking out a 401(k) loan. The money you take out or your account is no longer working for you earning returns, and even though it will get repaid over time, that can set back your retirement savings. Loans that aren’t paid back on time are considered distributions and are subject to taxes and early withdrawal penalties for people younger than 59 1/2.
What Are the Special COVID-19 Hardship rules?
With the CARES Act of 2020, the federal government provided a number of relief measures to ease financial burdens on those affected by the COVID-19 pandemic. One of these measures eases restrictions on coronavirus-related 401(k) hardship withdrawals made in 2020. The act allows individuals to access up to $100,000 of their retirement savings without early withdrawal penalties. It also provides an expanded window of time to pay any income tax that may be due on the withdrawal.
Normally, people who make hardship withdrawals are not allowed to repay that money to their 401(k) plan. However, under the CARES Act, qualified individuals have the option to repay their withdrawal over the course of three years without having the amount recognized as taxable income.
To qualify for this program, you, your spouse, or your dependent must have been diagnosed with COVID-19, or your finances must have been hurt by COVID-19-related conditions, such as layoffs, furloughs, reduction in pay or hours, or the closing of a business.
A 401(k) hardship withdrawal can be an important tool for individuals who have exhausted all other options to solve their financial problem. Before deciding to make a hardship withdrawal, it’s a good idea to carefully consider the potential drawbacks, including taxes, penalties, and the permanent hit to a retirement savings account.
It’s also important to know that money in a 401(k) account is protected from creditors and bankruptcy. For anyone considering bankruptcy, taking money out of a 401(k) plan might leave it vulnerable to creditors.
Other options may make more sense, such as working with creditors to come up with an affordable payment plan, or taking out a 401(k) loan, which allows an individual to replace the borrowed income so that their retirement savings can continue to grow when the loan is repaid.
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