Life is full of surprises, and they aren't always welcome when it comes to money. If you're in a financial bind, it can be tempting to tap into your 401(k) plan to make ends meet. However, hardship withdrawals can end up creating more hardship down the road, so you should understand the basics (and the alternatives) before you even consider taking one.
What is a 401(k) hardship withdrawal?
Unlike a loan with repayment terms and an attached interest rate, a 401(k) hardship withdrawal is exactly what it sounds like: removing a lump sum from your retirement plan to cover financial hardship.
Not everyone has the option of taking a hardship withdrawal. Assuming your 401(k) plan allows hardship withdrawals, which it is not legally required to do, you'll need to meet certain requirements.
According to IRS regulations, a 401(k) hardship withdrawal is only allowed if you, your spouse, dependent, or adult child experience "heavy financial need" (which the IRS does not define) and don't have any other assets or savings available. Qualifying expenses include:
- Medical bills
- Costs related to buying your primary residence (not including mortgage payments)
- Postsecondary tuition and other education-related expenses for the next 12 months
- Funds to prevent home foreclosure or rental eviction
- Home repairs, usually caused by sudden and unexpected circumstances
- Funeral expenses
If your circumstances don't fall within these parameters, then your plan administrator will likely ask for documentation detailing why you need the funds. In either case, if the withdrawal is approved, you can only take out enough to cover the hardship plus associated costs like late fees, taxes, etc.
Expect taxes and penalties (with a few exceptions)
Hardship withdrawals are subject to income taxes (excluding Roth 401(k) contributions) and a 10% penalty tax. For instance, suppose your income falls within the 28% income tax bracket, and you need to withdraw $40,000. You'll pay $11,200 in income taxes plus a $4,000 penalty for a total of $15,200.
You can avoid paying a 10% penalty in some cases. You may be exempt from the penalty in scenarios including these common ones:
- You're aged 59-1/2 or older.
- You've become totally and permanently disabled.
- The funds are needed to satisfy a court order, e.g., alimony, child support, or an IRS levy.
- The funds go toward medical debt exceeding 7.5% of your gross adjusted income (or 10% if you're under age 65).
- You're a service member called to active duty.
- You're rolling the funds over to an IRA.
It'll cost you more than the taxes and penalties
Whether or not you pay taxes and penalties on your withdrawal, you'll still lose valuable retirement income. The table below illustrates how much a single withdrawal of $40,000 could cost you, assuming the funds withdrawn would otherwise have earned 7% per year in your 401(k).
Future contribution restrictions
If that weren't enough, there's one more unpleasant surprise in store: The IRS prohibits your contributions to your 401(k) plan for six months after the withdrawal. This may seem like a small price to pay, but even $1,000 in missed contributions could cost you more than $7,600 over the course of 30 years, assuming a 7% return.
Hardship withdrawal alternatives
Withdrawing 401(k) funds should always be a last resort, and alternatives like the ones below are less likely to damage your retirement plans.
- Delaying major purchases. If waiting is an option, it's worth it to hold off on making a huge purchase like a home until you have the cash in hand. If you're anxious to make a change, consider temporarily diverting your retirement savings into a liquid account or high-growth stocks to supercharge your saving efforts.
- Education grants and scholarships. An education is a valuable asset, but you may regret paying for that degree when you can't afford to retire. Contact your college's financial aid department to learn about grants, scholarships, and other financing options.
- Individual payment agreements. If you're trying to wipe out debt, raiding your retirement fund is rarely the best way to do it. Creditors are often willing to work with loyal customers. For instance, your physician's billing department probably offers a payment plan to help you get control of your medical bills. If there's no hope that you'll up with your debt, then your creditor may even agree to lower your balance; they'd rather get something out of you than nothing. So don't respond to debt with panic. Take a breath and work with your creditors to find a smart solution.
- A 401(k) loan. Depending on your situation and your 401(k) plan provisions, the IRS may require you to take out a 401(k) loan before considering a hardship withdrawal. While this option still comes with drawbacks -- like interest on the loan (which you repay to yourself), borrowing limits, and missed earning potential -- you won't lose hard-earned cash to taxes and penalties.
Financial hardship can be incredibly stressful, but compounding the problem with additional losses won't help you in the long run. Take advantage of every other option before tapping into your retirement savings. Future you will be glad you did.
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