Making a 401(k) Hardship Withdrawal
If you have a 401(k) plan, you may be able to take money out to cover your emergency expense. Called a 401(k) hardship withdrawal, this option lets you withdraw only the amount necessary for the hardship, which you’ll have to prove through supporting documentation.
- With a 401(k) hardship withdrawal, plan participants can take money out of their 401(k) plans to cover financial emergencies.
- Not all plans offer hardship withdrawals, and those that do will require that you have a qualifying hardship and be able to prove that hardship through documentation.
- Hardship withdrawals come with a 10 percent penalty, along with the income taxes you’ll have to pay on the amount.
Life happens. Even if you work hard and set money aside, an emergency can put you in deep debt, possibly even putting you at risk of losing your home.
If you have a 401(k) plan, you may be able to take money out to cover your emergency expense. Called a 401(k) hardship withdrawal, this option lets you withdraw only the amount necessary for the hardship, which you’ll have to prove through supporting documentation. Before you go this route, though, here are a few things you need to know about hardship withdrawals.
How to Make a 401(k) Hardship Withdrawal
If you want to make a 401(k) hardship withdrawal, the first place to check is with your employer. Not all employers allow hardship withdrawals. This should be outlined in your plan documentation, but you can also simply ask your HR department about it.
To make a hardship withdrawal, you’ll likely need to complete an application that will then be reviewed and either approved or disapproved. You will have to offer details of the hardship. This means you’ll need to hand over personal financial details, which could include:
- Bank statements
- Insurance bills
- Funeral expenses
- Escrow paperwork
This request for information is not meant to be intrusive. Your employer’s plan administrator must follow 401(k) hardship withdrawal rules as outlined by the IRS. By gathering and saving this information, plan administrators are able to demonstrate they’re following regulations when it comes to managing their retirement savings plans.
Eligibility for a Hardship Withdrawal
Before you can take a hardship withdrawal, it can help to first know what is hardship. The IRS requires all plans that allow hardship distributions to describe what qualifies as a hardship.
But your plan’s definition must also fit the IRS’s definition of a 401(k) hardship. To qualify, the employee must have an “immediate and heavy financial need,” and the amount being requested has to be necessary to fulfill that need.
Here are a few examples of events that might qualify you for a hardship distribution 401(k):
- Medical expenses
- Home-buying costs for a primary residence
- Tuition and other higher education costs for the upcoming 12 months
- Eviction or foreclosure prevention
- Funeral expenses
- Repairs of damage to a primary residence
It’s important to note that the need doesn’t have to apply to you. You could take a hardship distribution from your 401(k) for your spouse. Some expenses, such as medical and funeral costs, can also apply to your child and other dependents.
How Much You Can Withdraw?
When you complete a 401(k) withdrawal form to request a hardship withdrawal, you’ll be asked the amount. You can only request the amount necessary to cover the expense, which you’ll document when you apply.
There are special circumstances, though, where a cap may be set on the amount you can take out. One of the most recent examples of that is the hardship withdrawal that has been allowed under the COVID pandemic. The CARES Act lets 401(k) plan participants take a withdrawal of up to $100,000 without paying a penalty. But you do have to pay taxes on the amount. You’ll claim the income in three equal portions over the next three tax years. You can also claim it all at once.
The Downsides of Hardship Withdrawals
Even if you have solid hardship withdrawal reasons, it’s important to think long and hard before going this route. You’ll lose significant money in penalties and taxes, so often alternative funding sources will be a better option.
The first thing you’ll be hit with is a 10 percent penalty for taking the funds out early. If you take out $50,000 to pay medical bills, that means you’ll have to hand $5,000 of that over to the IRS.
But perhaps the biggest hit comes in taxes. Even if you’ve taken the withdrawal during a hardship like COVID-19, when the 10 percent fee is waived, you’ll be taxed on the withdrawal as ordinary income. The withdrawal will be added to your overall income for the year, which means it could throw you into a higher tax bracket.
Even if you toss the taxes and penalties aside, there’s another good reason to leave your retirement savings alone. Your 401(k) hardship withdrawal reasons will eventually be resolved and you’ll be facing months, possibly years, of lost interest on the money you once had in the plan. If you can never afford to put the money back, you could suffer a setback in making sure you have enough to retire comfortably someday.
Options for Getting 401(k) Money
There is one alternative to withdrawing your money. Some plans will let you take a 401(k) hardship loan. You’ll have to repay the loan under the terms outlined in the plan in order to avoid paying taxes on the money you take out.
One last option is a non-hardship, in-service withdrawal, which not all plans will allow you to take. This provision lets you take a withdrawal from your employer’s 401(k) even without meeting the financial hardship definition. You still may need to meet certain qualifications to take money out under these circumstances.
If you have a qualifying event that meets IRS hardship rules, a 401(k) withdrawal may be a way to get some extra money. But you’ll pay taxes and penalties on the withdrawal in most cases. A loan could be a better option. Before you make any moves, we recommend reviewing your options with a Certified Financial Planner®. There could be a less costly way to regain your financial footing.