If you’re short on funds and looking for resources to get through an emergency situation, you may have considered taking money out of your 401(k) plan. There are several specific circumstances when current employees can take 401(k) withdrawals to cover sudden costs.
Retirement accounts are typically set up to allow withdrawals starting at age 59 1/2, and individuals who take distributions before that age can usually expect to pay a 10% penalty and income tax on the amount withdrawn. However, some plans make it possible for participants to take out funds early, if certain requirements are met.
The following steps will walk you through when a 401(k) hardship withdrawal might be necessary, the process of taking a hardship withdrawal and what to consider before making a decision.
Reasons for a 401(k) Hardship Withdrawal
A 401(k) hardship withdrawal is allowed by the IRS if you have an “immediate and heavy financial need.” The IRS lists the following as situations that might qualify for a 401(k) hardship withdrawal:
— Certain medical expenses.
— Burial or funeral costs.
— Costs related to purchasing a principal residence.
— College tuition and education fees for the next 12 months.
— Expenses required to avoid a foreclosure or eviction.
— Home repair after a natural disaster.
Employers set the requirements for hardship withdrawals when they set up the 401(k) plan for their workers. “Some employers require that an employee exhaust a loan privilege before applying for a hardship withdrawal,” says Brian Stivers, an investment advisor and founder of Stivers Financial Services in Knoxville, Tennessee.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
401(k) Hardship Withdrawal Rules
Before making the withdrawal, you will need to check if your specific 401(k) plan provides the option of 401(k) hardship withdrawals. Not all plans permit you to take a hardship withdrawal. “It’s up to the plan sponsor to decide whether to allow hardship withdrawals,” says Kyle Ryan, executive vice president of advisory services at Personal Capital in Danville, California. If your account provider does permit you to take out funds, you’ll have to show that you don’t have other available funds to cover the expenses.
A qualifying financial need doesn’t have to be unexpected. An expense may be considered immediate and heavy even if it is an event you knew was coming or voluntarily pursued. But there are also many costs that will not be determined to be immediate and heavy. A consumer purchase, such as a boat or television, would not usually be viewed as a qualifying factor for a hardship distribution.
401(k) Hardship Withdrawal Limits
For those who meet the criteria to qualify for a 401(k) hardship withdrawal, the next step is to determine the amount you can take out. In most cases, you’ll be allowed to withdraw only what you need. For example, if it will cost $10,000 to fix your house after an earthquake, you won’t be able to take out more than that for the repair. You may be allowed to take additional funds to help cover related costs, such as the taxes to be paid on the transaction.
When taking a hardship withdrawal, the funds will be subject to income tax, and you may also need to pay a 10% early withdrawal penalty if you are under age 59 1/2. During 2020, the CARES Act allowed for withdrawals of up to $100,000 for COVID-related costs with no 10% early withdrawal fee. The CARES Act also gave the option of making the tax payments during a three-year time frame. If you withdrew funds for COVID-related expenses in 2020, “The income along with the tax can be recognized over three years, allowing the spread of income and taxes over a greater period of time,” says Steven Weil, president and tax manager of RMS Accounting in Fort Lauderdale, Florida.
[Read: How Much Should You Contribute to a 401(k)?]
401(k) Hardship Withdrawal Documentation
To receive the funds, you will need to talk to your plan sponsor, who might be a human resources representative at your workplace or a financial advisor assigned to the plan. “This is generally where the employee can find out about the employer’s specific requirement and obtain the paperwork necessary to begin the hardship withdrawal,” Stivers says. “Generally speaking, the paperwork necessary to apply for a withdrawal will either be by paper or online.”
Consequences of Taking a 401(k) Hardship Withdrawal
In some cases, funds removed from a 401(k) for a hardship may not be returned to the account. Once you spend your retirement funds, you lose out on the amount saved and the additional interest that could have accumulated in the account for retirement. “Every dollar withdrawn from your 401(k) early is a dollar that isn’t there for retirement,” Ryan says. “In addition, you lose the opportunity for these funds to grow on a tax-deferred basis over the long term, which could potentially grow your nest egg even more.”
Among the reasons for taking a hardship withdrawal, using funds to help purchase a home where you will live may have the least negative impact. “A home does appreciate over time much like an investment,” says Ben Barzideh, a wealth advisor at Piershale Financial Group in Barrington, Illinois. “There are also emotional and psychological benefits to owning a home.”
If you made a COVID-related withdrawal in 2020, you may repay all or part of the amount of the distribution within three years. However, the funds you receive are considered income and could impact your eligibility for government benefits. “The income recognized could affect the amount of any Obamacare credit and even make part of the credit subject to repayment,” Weil says. “It could also affect the amount of Social Security subject to income tax.”
Money held within a qualified retirement plan is typically protected from lenders. When you withdraw funds from a 401(k), they could become subject to the claims of creditors. “If a personal bankruptcy or long-term inability to pay your obligations looms on the horizon, it may be best to leave your money tucked away in your retirement plan where it is free from the claims of creditors, except the IRS,” Weil says.
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
Alternatives to a 401(k) Hardship Withdrawal
Rather than a withdrawal, it might be possible to take a 401(k) loan. In most cases, the loan will be limited to a certain amount, and you’ll need to pay it back over a specific period of time, which is usually less than five years, along with interest. If you leave your job before paying off the loan, the balance will be considered a withdrawal and become subject to income taxes and also a penalty if you are not yet 59 1/2 years old.
If you’re over age 59 1/2, you might be able to take distributions from your 401(k) account without any penalties. And for early retirees, the IRS allows penalty-free distributions for those 55 or older who have left the workforce. The age is lowered to 50 for retired public safety professionals, such as police officers and firefighters.
More from U.S. News
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How to Take 401(k) Hardship Withdrawals originally appeared on usnews.com
Update 11/18/22: This story was published at an earlier date and has been updated with new information.
