401(k) Hardship Withdrawals: What You Need To Know
If you have a 401(k) account at work, you might be wondering if you can access those funds before retirement. And if you’ve recently lost a job or suffered a financial emergency, draining your retirement accounts to cover your needs might seem like a good idea.
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But while the IRS does allow for early withdrawals from your 401(k) account, there are a few hoops you need to jump through to avoid penalties. And unfortunately, some 401(k) plan custodians don’t even allow hardship withdrawals from your plan. Plus, you’ll end up paying taxes and possibly IRS penalties to access your funds, so it’s important to understand exactly how a 401(k) hardship withdrawal works.
What Is a 401(k) Hardship Withdrawal?
A 401(k) hardship withdrawal is the process of accessing funds in your workplace 401(k) account before retirement age (currently age 59 ½). While there are typically penalties for withdrawing funds prior to retirement age, a hardship withdrawal allows certain individuals to access specific funds within retirement accounts without paying a 10% IRS penalty.
Not all 401(k) accounts allow you to withdraw funds early, so you’ll need to check with your plan administrator to see if a hardship withdrawal is allowed. And even if it is allowed, you may need to provide documentation of your financial hardship to qualify.
While certain circumstances will waive the 10% IRS penalty, you’ll still owe income taxes on your 401(k) hardship withdrawal.
401(k) Hardship Withdrawal: What You Need To Know
There are some rules you need to follow to perform a 401(k) hardship withdrawal and avoid massive penalties. Here’s how it works.
Who Is Eligible?
Only individuals with a qualifying 401(k) account whose custodian allows hardship withdrawals are eligible to take early distributions without penalty. You’ll also need to prove an “immediate and heavy financial need” to avoid additional IRS penalties on your withdrawal if you’re under age 59 ½. The financial need can be for you, your spouse, your dependents or a beneficiary.
You’ll also need to exhaust other avenues of financial aid, including nontaxable distributions from other retirement accounts, insurance payouts, plan loans or other access to funds.
The IRS has outlined “safe harbor distributions” that automatically qualify for hardship withdrawals, including:
Medical care expenses
Costs related to purchase of principal residence
Qualified education expenses for the next 12 months of postsecondary education
Payments to avoid foreclosure or eviction from principal residence
Funeral expenses
Home damage expenses (such as roof repair)
Amount You Can Withdraw
The IRS states that you can’t simply withdraw as much as you want — hardship withdrawals are limited to the amount of your stated financial need. And your withdrawal only qualifies as a hardship withdrawal up to the amount of your financial need, minus any funding obtained from other sources.
You also cannot access any of the growth in your 401(k) account. The IRS states that you can only use your elective deferrals and company match, along with any nonelective contributions by your employer. For example, if you and your employer have contributed $50,000 to your 401(k) account, but your total balance is currently $100,000, you are only allowed to access up to $50,000 from that account.
What Are the Costs?
When you take a hardship withdrawal from your 401(k) account, there are typically no fees associated with the transaction (unless your custodian has a specific charge for it). But you will be subject to ordinary income taxes at your current tax rate, plus you may be on the hook for a 10% IRS penalty if any distributions are in excess of the agreed-upon financial need by your plan custodian.
How 401(k) Hardship Withdrawals Are Taxed
401(k) hardship withdrawals are taxed at your ordinary income tax rate. For example, if you’re filing as single on your tax return and your income puts you in the 22% tax bracket, hardship withdrawal funds will be taxed at 22%. So if you withdraw $10,000 from your 401(k) account as a hardship withdrawal, your tax burden may increase by up to $2,200.
How To Avoid Penalties
While hardship withdrawals are allowed by the IRS, you may be penalized on any funds withdrawn that don’t qualify for an exception. The IRS states that any withdrawal prior to age 59 ½ is considered “premature” and will assess an additional 10% penalty, with the exception of certain circumstances, including:
Birth or adoption expenses up to $5,000 (per child)
Total and permanent disability
Disaster recovery in a federally declared disaster area (up to $22,000)
Qualified higher education expenses
Series of substantially equal payments
Qualified first-time homebuyer expenses (up to $10,000)
Health insurance premiums while unemployed
Separation from employer during or after the year the employee reaches age 55
There are several other exceptions for very specific circumstances, which can be found on the IRS website.
How To Apply for a 401(k) Hardship Withdrawal
To apply for a 401(k) hardship withdrawal, you’ll first need to talk to your plan custodian. The IRS defers to custodians to set the parameters around hardship withdrawal applications and whether or not hardship withdrawals are permitted at all.
Your plan custodian usually has guidelines for the plan on what qualifies for hardship, and you may need to submit documentation to your plan custodian before withdrawing funds. Some custodians may even have a formal application process, but that will vary by employer.
Once you present your hardship information and any documentation requested, you can work with your plan custodian to facilitate the withdrawal. It’s important to follow any processes outlined by your 401(k) plan custodian to avoid any penalties from the IRS.
Alternatives to a 401(k) Hardship Withdrawal
A 401(k) hardship withdrawal should be a last resort for trying to access funds during a financial emergency. Not only are there taxes (and possible penalties) assessed on your withdrawal, but you also can’t put that money back. That means you’ll have less in your retirement account going forward, missing out on potential tax-free growth.
Here are a few alternatives to consider before raiding your 401(k) account:
401(k) Loan
A 401(k) plan loan allows you to borrow against the balance of your 401(k) plan. If your employer allows plan loans, you can borrow up to $50,000 or 50% of your vested account balance, whichever is less.
But a 401(k) loan has strict terms, and if you don’t repay the loan within five years or lose your job, you may be on the hook to repay the entire balance immediately. Any amount not repaid will be considered a distribution and hit with income tax and a 10% IRS penalty unless you elect to roll over the amount owed into an IRA. Proceed with caution when considering a 401(k) loan.
Roth IRA Withdrawal
Roth individual retirement accounts allow you to access principal investment funds without any tax consequences or penalties. Because the Roth IRA is a “posttax” retirement account, you’ve already paid taxes on the funds you contribute to the account. For example, if you contributed $30,000 to a Roth IRA over a five-year period, you can withdraw $30,000 from your account at any time without taxes or penalties. Just make sure you don’t withdraw more than your principal contributions — otherwise, you may be subject to income tax and a 10% IRS penalty.
Personal Loan
If you qualify for a personal loan, you can avoid touching your retirement accounts and potentially paying substantial penalties. Personal loans are not collateralized, meaning you don’t need to pledge assets to borrow the funds. But you usually need a high credit score and proof of income to qualify for a loan, so if you lost your job, this may not be an option.
0% Interest Credit Card
If you have an immediate need but expect the ability to repay the expense within a year or so, you may consider applying for a 0% interest credit card. Some cards offer 0% interest on purchases for up to 18 months or more. This can help you cover your immediate expenses while paying down the balance over time. Just make sure to pay the balance in full by the time the introductory 0% rate expires, or you may be hit with a large interest expense.
FAQ
What qualifies for a 401(k) hardship withdrawal?
According to the IRS, to qualify for a 401(k) hardship withdrawal, you need to show an immediate and heavy financial need. This definition is subjective, and ultimately, it's up to your 401(k) plan custodian to approve your request. There are a few circumstances that automatically meet the definition of an immediate and heavy financial need, including medical care expenses, funeral expenses, first-time homebuyer expenses (up to $10,000), payments to avoid foreclosure or eviction from principal residence, and more.
Can I take a 401(k) hardship withdrawal to pay off credit card debt?
You may be able to take a 401(k) hardship withdrawal to pay off credit card debt if your plan administrator allows it. You will need to prove that your debt is causing an immediate and heavy financial need and that you have exhausted all other sources of funding. But in many cases, this may not qualify for a hardship withdrawal. Plus, you're usually better off finding a 0% interest credit card and doing a balance transfer to avoid high interest rates.
How can I prove hardship for a 401(k) withdrawal?
To prove hardship for a 401(k) hardship withdrawal, you first need to tell your 401(k) plan administrator about your immediate and heavy financial need. This may require submitting documentation of financial hardship or other proof that you need access to your 401(k) funds early. Plus, you may need to submit proof that you've exhausted other avenues of funding, such as loans, liquidating assets, or nontaxable distributions from other plans.
How do I avoid a 20% tax on my 401(k) withdrawal?
If you're withdrawing funds from your traditional 401(k) account, you typically will be on the hook for income taxes owed. And if you're taking an early withdrawal, you may also be assessed an additional 10% IRS penalty tax. To avoid this extra 10% tax, you'll need to make sure your distribution is eligible, such as being used for a first-time homebuyer down payment, medical expenses or qualified higher education expenses. But you'll still owe ordinary income tax on any traditional 401(k) withdrawal. To lower the tax owed, it's best to work with a licensed tax professional to help prepare your return.
This article originally appeared on GOBankingRates.com: 401(k) Hardship Withdrawals: What You Need To Know
