For many Americans struggling to make ends meet, a 401(k) hardship withdrawal appears to be a viable option.
When job loss, unexpected health issues, or recession hit, you may find yourself in dire need of help.
House or rent payment. Utility bills. Late credit card notices. Debt collectors call you every hour on the hour.
Read on to decide whether or not to pursue a 401k hardship withdrawal to alleviate the burden.
401(k) Hardship Withdrawals FAQs
Do People Really Make 401(k) Hardship Withdrawals?
401(k) Hardship withdrawals have been on the rise. It rose by 24 percent over the 12 months that ended in September 2022, according to an Empower report released in November. The findings are based on an analysis of 4.3 million accounts in corporate retirement plans that Empower administers, and a survey of about 2,500 Americans.
Are you thinking of becoming part of the 24%? Sometimes the withdrawal rules can be confusing, so it’s important to know when you are allowed to pull money from your 401(k) because of hardship.
Read on to learn what actually happens when you make a 401(k) hardship withdrawal.
What Is a 401(k) Hardship Withdrawal?
A 401(k) hardship withdrawal is legally allowed if you meet the Internal Revenue Service criteria for having a financial “hardship” and if your employer allows for it.
Most companies providing 401(k) plans allow hardship withdrawals – check with your human resources department or plan administrator if you’re not sure.
What Are Acceptable Reasons for a Hardship Withdrawal?
The IRS considers the following list of items acceptable reasons for withdrawing money from your 401(k) under the hardship withdrawal.
The Pension Protection Act of 2006 extended your need for a hardship withdrawal to the needs of your beneficiary, even if the beneficiary is not your spouse or dependent.
- Medical expense: Un-reimbursed medical expenses for you, your spouse, or dependents.
- Home purchase: Toward the purchase of your principal residence.
- Foreclosure risk: To prevent foreclosure or eviction from your principal residence.
- Educational expenses: College tuition and related educational expenses for you, your spouse, or children.
- Funeral expenses: Offsetting the cost of final expenses.
- Home repair: Certain expenses for the repair of damage to your principal residence.
The IRS code will allow hardship withdrawals for the above-mentioned reasons only if you have no other funds or means to fulfill the need, and the withdrawal would be enough to satisfy the need (but not more than what you need).
You can, however, include the cost of withdrawal (penalties and taxes) in the amount you need.
Thanks to the Bipartisan Budget Act of 2018, you’re no longer required to take a loan from your 401(k) before being able to file for a hardship withdrawal.
Remember: You are not allowed to contribute to your 401(k) plan for six months after making a hardship withdrawal.
What Are the Tax Implications of a 401(k) Hardship Withdrawal?
If you must make a hardship withdrawal from your 401k before you reach the age of 59 and a half years old, your withdrawal will be subject to income tax and a 10% withdrawal penalty.
You don’t have to pay back the money withdrawn like you would a loan from a 401k, which means your retirement account balance is permanently reduced by the amount of your hardship withdrawal.
How Do You Prove Need for 401(k) Hardship Withdrawal?
Each plan administrator can specify what documentation is required for proof of the financial need for a hardship withdrawal.
If the money is used to prevent home foreclosure, the administrator may require documentation from the mortgage company that the home is about to enter foreclosure, for example.
What Is the Allowed Amount of Hardship Withdrawals?
How much money can be taken from a 401(k) plan in the form of a hardship withdrawal? Rather than setting a specific number, the maximum amount cannot exceed the total amount of your contributions, and cannot be more than your financial need.
Alternatives to a 401(k) Hardship Withdrawal
529 Savings Plan
If you have saved up money for your kids’ college, you may be better served by tapping your 529 College Savings Plan first. Why?
While earnings are subject to tax, you can withdraw your contributions penalty-free. Even if there are earnings in the account, they may be minimal compared to the penalties you would pay for your 401k hardship withdrawal.
Peer-to-peer lending sites have become increasingly popular nowadays. With these programs, you apply for a loan just like you would through a bank.
But instead of a financial institution lending you the money, peers or other individuals loan you the money. One of the more popular peer-to-peer lending sites is Lending Club.
Another option might be to get a personal loan. You might be able to borrow or refinance your mortgage to save money. You might want to also consider applying for an unsecured consumer loan.
Use PersonalLoans.com to get matched up with a good lender and see what your interest might be. Take those rates and compare that figure with your penalty for the hardship withdrawal.
Should You Use a 401(k) Hardship Withdrawal?
Using a 401(k) hardship withdrawal should only be done as a last resort. Look for all other options for accessing money before tapping into your 401(k) retirement savings.
A 401(k) hardship withdrawal reduces the amount of your retirement account permanently. While it may help you in the short term, a 401(k) hardship withdrawal can throw a real wrench in your long-term retirement goals.
Since it’s never repaid, you’ll miss out on compounding interest and earnings, and most likely pay both income taxes and penalties on the amount withdrawn, making it an expensive option for gaining access to your money.
Personally, I would like to see people attempt another option. Before you take the leap and withdraw from your 401k, be sure to meet with a financial advisor to explore all your options.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.