It's not uncommon for a household at any income level to run into temporary money shortages. The initial problem may be a sudden large expense, a loss of income, or snowballing credit card debt. But whatever the cause may be, digging yourself out of such a deep financial hole can be next to impossible. And that's when a 401(k) hardship withdrawal can provide you with a lifeline.
What is a hardship withdrawal?
A 401(k) hardship withdrawal is an early withdrawal from your workplace retirement savings account due to "immediate and heavy financial need of the employee," in the words of the IRS. To meet the basic requirements for a hardship withdrawal, the expense you're paying with the money must be one of the following: medical bills, a new primary residence, tuition or educational expenses, payments to prevent eviction or foreclosure, burial or funeral expenses, or repairs for certain types of damage to your home. You must also have no other available resources to pay for the expense.
Not all 401(k) plans allow for hardship withdrawals. Some plans will require you to take a 401(k) loan instead, while others may have tighter limitations on hardship withdrawals than the IRS does. For example, a given plan may allow hardship withdrawals for paying medical expenses, but not for paying tuition.
Taking a hardship withdrawal
Assuming you meet the requirements and your plan allows it, you can take a 401(k) hardship withdrawal that's enough to pay the qualifying expense, but no more than that. You're also limited to taking no more than you've contributed so far to the 401(k); the returns on those contributions are off limits. For example, if you've contributed a total of $10,000 but the value of the investments in your 401(k) is actually $15,000, you still can't take more than $10,000 in a hardship withdrawal.
The IRS hardship withdrawal rules allow your employer to take your word regarding your financial status and lack of other resources, so you won't necessarily have to prove how dire your situation is through bank statements and so on. However, if your employer knows you have other resources available to you (for example, if you're eligible for a 401(k) loan), then they must deny you the hardship withdrawal.
Consequences of a hardship withdrawal
While a hardship withdrawal can be extremely helpful for someone facing serious financial problems, it also has some major consequences. First, unless you're taking the money from a Roth account, you'll have to pay income taxes on the withdrawal. If you withdraw $10,000 from your 401(k) and you're in the 25% tax bracket, then you'll end up paying $2,500 in taxes on that withdrawal when you file your tax return for the year. That also means you'll only be able to use $7,500 of that $10,000 distribution.
Second, your employer may not allow you to contribute to your 401(k) or any other employer-provided plan for six months after taking the withdrawal. And third, by taking money out of your retirement savings accounts early, you'll substantially reduce the amount you have in the account after you retire.
When you take money out of your retirement accounts early, you're not just losing the money you take out; you're also losing all the returns that money would've generated. For example, let's say you take $10,000 from your 401(k) as a hardship withdrawal 20 years before your planned retirement date. If you had left that $10,000 in your account, and it had returned an average of 8% per year, then by your retirement date that money would've become $46,610. In short, taking $10,000 now costs you $46,610 in retirement.
If you truly have no alternatives and are facing something like a necessary medical service you can't afford, or eviction from your home, then a 401(k) hardship withdrawal may be your best option. However, if you take such a withdrawal, you'll need to act as soon as possible to repair the damage by jacking up your future contributions as soon as you're able to continue making them. If you don't, you could be facing even bigger financial hardships once you retire.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.