Faced with rising household costs, many Americans are turning to their retirement accounts to save their homes from foreclosure.
According to a recent report from Vanguard, 3.6% of American retirement savers raided their 401(k) plan to cover significant household shortfalls in 2023, up from 2.8% the previous year. Home foreclosures were the biggest challenges for hardship withdrawals, with 39% of all retirement fund withdrawals in 2023 taken to bypass a home foreclosure or eviction, according to the report. That’s up from 31% since 2021.
Financial hardships are undoubtedly a harsh reality for Americans and have been for a while.
“There are times when potential debt is unavoidable, and that’s simply life,” said Anthony DeLuca, a certified financial planner at RetireGuide.com in Longwood, Florida, in an email. “That’s why certain hardship withdrawals are the correct move to avoid debt, even if it means your retirement plan takes a step backward.”
When determining if a hardship withdrawal is right for you, consider the following:
— Retirement plan withdrawals explained
— Pros and cons of taking a hardship withdrawal
— Good reasons to take a hardship withdrawal
— Making up ground after a hardship payout
— Ways to avoid taking a hardship withdrawal
Retirement Hardship Withdrawals Explained
A retirement fund hardship withdrawal is when you take money from your 401(k), 403(b), Roth or traditional IRA or any other retirement account and use it for a personal financial expense.
“These withdrawals are meant to cover an immediate and heavy financial burden like medical care or funeral expenses for you, your spouse and dependents or beneficiaries, purchase of a primary residence, college expenses, eviction prevention payments and certain expenses to repair damages on a primary residence,” said Christian Mundy, a senior wealth advisor at LifeLine Wealth Management in Beverly Hills, California, in an email. “The amount you’re allowed to withdraw is limited to the amount needed to cover the need, and other funds can’t be available to cover such expenses.”
Retirement accounts are typically invested in funds composed of stocks and bonds. “Therefore, a liquidation is needed to convert those holdings into cash to facilitate the withdrawal,” Mundy said.
The IRS retirement payment withdrawal instructions are very broad, but the borrower’s retirement plan documents will likely provide more detail. “Always know this withdrawal is not a loan,” DeLuca said. “When the money is out, it’s out for good.”
Retirement plan hardship withdrawals will be taxed at one’s ordinary income bracket. “Also, if the employee is under 59 1/2, they will also be taxed a 10% penalty,” noted DeLuca.
[READ: Retirement Accounts You Should Consider.]
Exceptions to the IRS Withdrawal Penalty
If you absolutely need to withdraw cash from your retirement, there are a few ways you can do so without paying any IRS penalties — but there are caveats.
The IRS recently greenlit an annual penalty-free $1,000 emergency withdrawal from retirement accounts, meaning you can take the loan without fear of penalty once every year. Granted, $1,000 isn’t a ton of cash, but it can cover common household costs like auto repairs and smaller emergency medical costs, among other immediate financial crises.
Not all employers have the emergency-expense provision in their 401(k) plans, so make sure to ask your company benefits representative before withdrawing the $1,000. Note that you’ll still need to cover income taxes on the withdrawal if you don’t repay the loan.
There are other exceptions to the IRS withdrawal penalty:
— Medical expenses for unreimbursed payments over 7.5% of one’s adjusted gross income
— Permanent disability, terminally ill or death
— Separation from service after age 55
— Court requirements regarding family matters
— 50% of the amount or $10,000 if a victim of domestic abuse
Pros and Cons of Taking a Hardship Withdrawal
While it may seem like there are only downsides to a retirement hardship withdrawal, there are some upsides — at least in the short term.
The Main Pro
Hardship withdrawals allow you to cover your unexpected financial burden without going into debt and waive the 10% early penalty on the funds taken. “You still must pay taxes on the withdrawal unless it consists of a Roth IRA contribution,” said Mundy.
The Main Con
Retirement plan withdrawals reduce your retirement progression and growth potential as it may take longer to reach your retirement goals. “It may require increasing contributions to your portfolio, add risk to your investment profile and lead you to continue to work longer than expected because of the withdrawal,” Mundy noted.
Good Reasons to Take a Hardship Loan
In many cases, a retirement hardship withdrawal can be useful in dealing with unexpected expenses. Some reasonable scenarios in which to take a hardship loan include:
For unavoidable personal expenses
The best reason to dip into your retirement savings is when faced with sudden and unavoidable misfortune. “For instance, covering significant medical expenses for yourself or loved ones is crucial. Health emergencies can’t wait,” said Megan Yost, senior vice president at Segal Benz, a human resources and benefits company in Boston, in an email. “Also, preventing foreclosure or eviction or funeral expenses for loved ones are potentially vital reasons.”
These situations may justify a hardship withdrawal because “they are urgent needs that require immediate financial intervention and can result in larger fallouts if not addressed promptly,” she added.
For a new home
A hardship withdrawal can be used to make a down payment on a primary residence if you can’t raise the cash otherwise.
“While you’ll pay a 10% penalty and taxes on the distribution, it can help you build equity and potentially benefit you in the long run,” said Justin Haywood, a certified financial planner at Haywood Wealth Management in Houston, in an email.
For additional household expenses
Justifiable reasons for hardship withdrawals also include disability-related costs and primary residence repairs.
Retirement funds also offer an immediate financial fix when a natural disaster strikes and your home suffers major damage. Even so, you should consider all potential funding options before tapping your retirement accounts.
“In the event of a hurricane, tornado or other major weather event, it’s important to explore other options such as disaster relief programs or loans before tapping into your retirement savings,” said Glen Hedrick, a financial advisor at Old North State Wealth Management in Wilmington, North Carolina, in an email.
For eviction or foreclosure
If you’re facing eviction or foreclosure and you don’t have the funds to catch up on payments, a hardship withdrawal may be necessary. But first make sure you’ve thoroughly considered all possibilities. “Try exploring other options, such as loan modification or refinancing, before tapping into your retirement savings,” said Hedrick.
[Read: What Is a Good Monthly Retirement Income?]
Making Up Ground Once You’ve Taken a Hardship Payout
Once the loan is taken out, it’s important to get your savings back on track to provide sufficient income in retirement.
“That usually means increasing how much you contribute from your paycheck in a way that’s still sustainable with your other financial obligations,” said Yost. “Many retirement accounts, like 401(k) plans, also allow participants who are 50 and older to make catch-up contributions to their accounts, which allows them to save even more for retirement above the annual IRS limit.”
[Related:7 Things to Know About Withdrawing Money From a Traditional IRA]
Ways to Avoid a Retirement Hardship Withdrawal
One of the best ways to avoid using hard-earned retirement plan money is to build an emergency savings account.
Having an emergency fund can mitigate the impact of two types of financial loss: income shocks and spending shocks.
Spending shocks are basically unplanned financial expenses, like a medical procedure or a major car repair. Income shocks like a job layoff or major investment loss can be even worse.
To cover both, build a fund for spending shocks. Aim for one or two months of savings equal to your gross monthly income. For example, if you normally have $5,000 in monthly expenses, aim to save $5,000 or more to secure your emergency “spending shock” account.
For income loss, which happens less frequently than spending shocks, take a longer-term view and aim for a $15,000 to $20,000 “income loss” emergency fund. In most cases, saving this amount will take significantly longer than fully funding a spending shock emergency plan.
Take it slow and stash cash regularly into an interest-earning bank savings account. If you keep at it and don’t raid the funds, your income loss emergency fund can be fully funded in a year and a half or two years, depending on your annual income level.
Cash-needy consumers may also opt for a Roth IRA withdrawal, which has some advantages when you’re in a financial pinch.
“If you have a Roth IRA, you may want to tap into this money first,” said Kendall Meade, a financial planner at SoFi in Charleston, South Carolina, in an email. “With a Roth IRA, you can withdraw any of your contributions without penalties or taxes, (but) just the money you contributed, no earnings.”
More from U.S. News
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When a Retirement Hardship Withdrawal Makes Sense originally appeared on usnews.com
Update 07/17/24: This story was previously published at an earlier date and has been updated with new information.
