I have several clients that were laid off from a major manufacturer several years ago and are still struggling to find work.
For many Americans, this is an all too familiar situation.
House or rent payment. Utility bills. Late credit cards notices. Debt collectors calling you every hour on the hour.
All these add to the daily stress of you wondering how you’re going to make it financially. When times get tough and people have nowhere to turn, many look to their 401k to help bail them out.
401k Hardship withdrawals have been on the rise. According to a study by Fidelity this past August, 2.2% of all 401(k) participants had made a hardship withdrawal at some point over the preceding 12 months. That’s up from 2% in the prior year, and was the highest level in 10 years.
Are you thinking of becoming part of the 2.2%? Sometimes the withdraw rules can be confusing, so it’s important to know when you are allowed to pull money from your 401k because of hardship.
What is a 401k Hardship Withdrawal?
A 401k hardship withdrawal is legally allowed if you meet the Internal Revenue Service criteria for having a financial “hardship” and if your employer allows for them. Most companies providing 401k plans allow hardship withdrawals – check with your human resources department or plan administrator if you’re not sure.
Acceptable Reasons for a Hardship Withdrawal
The IRS considers the following list of items acceptable reasons for withdrawing money from your 401k under the hardship withdrawal. The Pension Protection Act of 2006 extends your need for a hardship withdrawal to the needs of your beneficiary, even if the beneficiary is not your spouse or dependent.
- Un-reimbursed medical expenses for you, your spouse, or dependents
- Toward the purchase of your principal residence
- To prevent foreclosure or eviction from your principal residence
- College tuition and related educational expenses for you, your spouse, or children
- Funeral expenses
- 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.
Remember: You are not allowed to contribute to your 401k plan for six months after making a hardship withdrawal.
Tax Implications of a 401k 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 401k Hardship Withdrawal?
Each plan administrator can specify what documentation it requires for proof of 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.
Allowed Amount of Hardship Withdrawals
How much money can be taken from a 401k plan in the form of a hardship withdrawal? The maximum amount can not be more than the total amount of your contributions, and cannot be more than your financial need.
If you have save up money for your kids college, you may be better served tapping your 529 College Savings Plan first. Why? While earnings are subject to tax and penalty, 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.
Another option might be get a personal loan. You might be able to borrow or refinance your mortgage that could save you 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.
Lastly, peer to peer lending sites have become increasing 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.
Should You Use a 401k Hardship Withdrawal?
Using a 401k hardship withdrawal should only be done as a last resort. Look for all other options for accessing money before tapping into your 401k retirement savings. A 401k hardship withdrawal reduces the amount of your retirement account permanently 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 make the move, 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.