I recently wrote about 401(k) loans and how they can torpedo your retirement savings. Some people asked about hardship withdrawals and whether they are a better option. Here are some things you should keep in mind before considering a hardship withdrawal.
What is a hardship withdrawal?
A hardship withdrawal is a distribution from your 401(k) plan to address a specific financial need. This is a payout from your account, not a loan that you will pay back over time. The IRS allows withdrawals only for certain reasons, including medical expenses, costs to purchase or to repair damage to your principal residence, tuition, prevention of eviction or foreclosure, and for funeral expenses.
Hardship withdrawals are subject to income tax, and may also be subject to the 10% early withdrawal penalty. While most 401(k)s offer hardship withdrawals, they are not required to. Also, an employee who takes a hardship withdrawal is not allowed to contribute to their retirement plan during the six months after the distribution.
Heavy need
The IRS specifies that a hardship must be due to an immediate and heavy financial need, and that the withdrawal is limited to the amount necessary to satisfy that need. Consumer purchases are not considered a heavy financial need, and any distribution cannot be greater than the financial need.
Advantages of a hardship withdrawal
After reading the above, you may wonder why anyone would want to take a hardship withdrawal. As you can imagine – and given the name – this becomes a realistic solution when your options are dwindling and you need immediate money. Some advantages of the hardship include:
Access to funds. If you are facing a severe financial situation, whether due to unexpected medical expenses or the possibility of foreclosure on your primary residence, a hardship withdrawal can provide a lifeline.
No repayment. Unlike a loan, you do not have to pay back the hardship distribution from your 401(k). In a time when your cash is at a premium, you are able to wipe the slate clean without having to worry about repayments.
10% penalty may be waived. In certain situations, especially for specific medical expenses or permanent disability, the 10% early withdrawal penalty may be waived. You will still pay taxes on your withdrawal.
No credit check. Like with a 401(k) loan, you do not need pristine credit for a hardship withdrawal. The administrator will not check your credit, relying instead on documentation to show the heavy and immediate need.
Disadvantages of a hardship withdrawal
Reduction in retirement savings. The distribution will immediately reduce your 401(k) balance, potentially impacting your future retirement. And unlike the 401(k) loan, you cannot pay this amount back. Plus, you will be subject to a six-month window when you can make no contributions, further reducing your savings. This lower account balance means you’ll miss out on potential long-term compound growth as well.
Taxes and penalties. With a hardship distribution, you could lose as much as 30% or more of your withdrawal to taxes and penalties. If you need $10,000 for a hardship, you would have to withdraw a little over $14,700 (if you were in the 22% tax bracket and had to pay the 10% early withdrawal penalty) to have enough to cover your need.
What to do if you need a hardship withdrawal
If you truly need a withdrawal, contact your HR department first to ensure this is available in your plan. If you have a copy of your Summary Plan Description, you can also check there or call your plan administrator. You will need to complete an application and provide proof of the hardship including the amount necessary to cover your immediate need. The process usually takes seven to ten business days.
Don’t try to cheat the government
I recently read about a person who was charged with fraud for receiving a hardship withdrawal and using it for other purposes. While the level of proof you’ll need will vary with your plan provider, make sure you save all bills, receipts and other information in case the IRS comes calling.
Options to a hardship withdrawal
As with the 401(k) loan, you should consider other options before taking a hardship withdrawal.
Personal or home equity loan. If you have good credit, a personal loan can provide quick funds with lower rates than a credit card. And if you’re a homeowner, you may borrow from the equity in your home.
Adjusting your contributions. Instead of taking money out of your account, consider temporarily lowering or stopping your contributions to free up monthly cash flow.
Roth IRA. Many people may not know this, but contributions to a Roth IRA can be withdrawn at any time with no penalty since they were after-tax contributions. Note that earnings cannot be withdrawn, only your contributions.
Household spending. Before taking any withdrawal, look closely at your budget to see if there are immediate cuts you can make. Also consider ways to increase your income, including selling personal assets or adding a part-time job.
If you find yourself in a situation where you need an immediate influx of cash and may not have the resources to repay a loan, a hardship withdrawal could be the right solution for you. However, carefully weigh other options before moving ahead. For reasons mentioned above, this should be only used as a last resort in case of a true emergency.
Photo by Markus Winkler