7 Things You Need to Know About 401(k) Hardship Withdrawals

By Dan Rafter on 23 January 2018 0 comments

You know it's a bad idea to take money out of your retirement plan before you turn 59 ½ years old. Not only will you face hefty financial penalties, you're risking your financial stability in the future. But what if you're facing an economic hardship and you're in dire need of the money?

If you have a traditional IRA or Roth account, you can take an early withdrawal at any time. In some cases, you can even avoid the withdrawal penalty, if you meet certain criteria. It's harder, however, to withdraw money early from your current employer-sponsored 401(k) plan. You'll need to check if your plan allows for an early withdrawal. Some plans will only allow contributors to take out what are known as hardship withdrawals before you hit age 59 ½.

The bad news is there aren't many situations in which you can qualify for these hardship withdrawals. And of course, taking money out of your 401(k) plan early is never an ideal financial move. (See also: 5 Dumb 401(k) Mistakes Smart People Make)

Here are a few key things you need to know about hardship withdrawals.

1. "Hardships" have set definitions

IRS rules spell out a narrow list of circumstances in which you can qualify for a hardship withdrawal. If you want to use your money for anything other than these special cases, you're out of luck.

For all scenarios, there must be an immediate and heavy financial need to take an early 401(k) withdrawal. Acceptable scenarios include unexpected medical expenses, tuition and educational fees, and burial or funeral expenses. You can also qualify for a hardship withdrawal for costs related to purchasing a home, if your home is damaged and you need to pay for repairs, and to keep yourself from being evicted or foreclosed on.

2. Hardship withdrawals come with big penalties

If you do need cash quickly, your 401(k) plan might seem like a logical place. After all, the money in your plan is yours. But a 401(k) plan is supposed to force you to save for your retirement, not be a source of emergency funds. That's why most plans won't allow you to take money out of them until employment with your company ends.

Hardship withdrawals are the exception to this. But if you use this exemption to take money out of a 401(K) plan before you turn 59 ½, you'll be hit with penalties. First, these early withdrawals are taxed as ordinary income. Even worse, your early withdrawal will also be hit with a 10 percent federal tax penalty.

This makes withdrawing 401(k) funds early, even for a financial hardship, painful. If you have an alternative way to get the money you need, you should take advantage of it. (See also: How to Come Up With $1,000 in the Next 30 Days)

3. There can be penalty exceptions

That 10 percent penalty is harsh, but there are circumstances in which you might not be hit with it. You might be able to avoid that penalty if you are disabled or if your medical debt is higher than 7.5 percent of your adjusted gross income. You might also avoid the penalty if a court has ordered you to give the money from a hardship withdrawal to a former spouse, a child, or a dependent.

4. Not all plans allow for hardship withdrawals

Not all 401(k) plans have the option to take hardship withdrawals. Your employer decided whether it wanted to offer such withdrawals when it set up its plan. There is no requirement from the IRS that employers offer such an option.

To determine if your plan allows for these withdrawals, contact your plan administrator. In most companies, this will be someone in your human resources department.

5. There are limits to your withdrawal

Even if you quality for a hardship withdrawal, you can't take out an unlimited amount of money. IRS rules state that you can only take money from your 401(k) account if you have no other funds to cover your hardship. And then, you can only withdraw enough funds to cover the costs of your financial emergency. You can't take extra dollars for a financial cushion.

6. You may need proof of your hardship

Your plan administrator may require proof that you need to take the hardship withdrawal. This might mean you'll have to provide your administrator with copies of medical bills, repair bills, or an eviction notice. You might also need to provide copies of your bank account statements proving that you don't have other funds available to cover your financial emergency.

7. When the money is gone, it's gone

After you take a hardship withdrawal, you are typically forbidden to make any deposits into your 401(k) account for six months. Once that six-month period ends, you are allowed to start depositing money back into your 401(k) account as you had been doing before.

This brings up what might be the biggest negative to hardship withdrawals: The money you take out of your 401(k) plan is gone forever. It is not a loan. You aren't simply borrowing it and putting it back. This could really hurt come retirement time.

This is why you should search for other means to cover your financial emergency. Turn to hardship withdrawals only as an absolute last resort. (See also: 3 Sources of Fast Cash Besides Your 401(k))

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7 Things You Need to Know About 401(k) Hardship Withdrawals

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