What is 401k Hardship Withdrawal?

A 401k hardship withdrawal is included in most 401k retirement plans – but not all of them are required to. Internal Revenue Service (IRS) rules state that hardship withdrawals are only permitted if it is needed to satisfy “an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need.” Financial needs of a 401k holder’s beneficiaries can satisfy this requirement.

To make a hardship withdrawal, an employee must have already obtained any other income available under the 401k plan. After making a hardship withdrawal, an employee can't contribute to their 401k plan for six months.

The IRS allows hardship withdrawals for:

  • Unreimbursed medical expenses of an employee or the employee’s spouse or dependents
  • The employee’s housing needs (rent, mortgage payment, or real estate purchase)
  • Tuition
  • Certain other necessary expenses

Income tax must be paid on amounts gained through hardship withdrawals. Those under 59 ½ years old also need to pay a 10 percent penalty for early withdrawal.

A Couple of Other Notes

It should be remembered that hardship withdrawal rules only apply when an employee is still working for the sponsor of the 401k. Once an employee is separated from their 401k sponsor, the hardship rules do not apply.

When is a 401k Hardship Withdrawal Allowed?

As long as the IRS criteria are met, a hardship withdrawal is allowed whenever the employer allows for it.

Hardship Basics

Hardship withdrawals are different than plan loans. They are more difficult to get, and more costly. They should only be taken if truly needed and there are no better financial options available.

Early withdrawal penalties can be avoided, however, if a person becomes totally disabled, if their medical debts exceed 7.5 percent of their Adjusted Gross Income, or if the money is needed to fulfill court ordered spousal or child support. Also, there is on penalty for those separated from their 401k sponsor after the age of 55.

Proof of Hardship

Employees must prove that they meet the hardship requirements laid out by the IRS in order to make a hardship withdrawal. Proof can be provided in the form of a financial disclosure, but self-certification is also permitted.  In most cases, a plan administrator can make this determination without undertaking a lengthy inquiry.

Loan Alternative

As soon as money is taken out of a 401k, it is taxed and cannot be returned. There is no “paying back” a hardship withdrawal. Once the withdrawal takes place, all the advantages the 401k offered evaporate.

That is why employees should avoid hardship withdrawals whenever possible. Some plans offer 401k loans, and these are almost always preferable. This is because loans are not taxed as income.

Plan holders should also consider taking out a loan from the IRA plan if they have one as an alternative to making a 401k hardship withdrawal.

Tax Pain

Don’t overlook taxes. Think about this cost before taking out a hardship withdrawal to make sure it is really financially worth it to you.

Taxes and Opportunity Costs

When withdrawals come from Roth IRA contributions, employees usually won’t pay income taxes on that money aside from any portion that comes from employer contributions.

Retirement Pain

Also, don’t overlook the impact that making an early withdrawal can have on your retirement plan.

Should You Use a 401k Hardship Withdrawal?

  • A 401k hardship withdrawal should be a last resort. Making an early withdrawal severely and permanently reduces your retirement fund. You will also miss out on any interest that you would have otherwise earned.
  • It should also be remembered that creditors cannot touch 401k money, and 401k funds are protected from bankruptcy. If someone is thinking about filing for bankruptcy, they should not take money out of their 401k.
  • Because there are such severe costs to a making a 401k early withdrawal, it is almost always better to loan money from other lenders when possible.

Allowed Amount of Hardship Withdrawals

A hardship withdrawal cannot be more than the total amount of the employee contributions. And as mentioned, it cannot exceed the amount needed to satisfy the financial need.

After You Take a 401(k) Hardship Withdrawal

After taking out a 401k hardship withdrawal, an employee cannot make new contributions to their 401k for the next six months. Even after that six-month period, there is no “paying back” the withdrawn money. Contributions can continue after six months have passed, but taxes on the withdrawn money still need to be paid.

Other Options

It could be a better option to take funds out of a college savings plan for children before a 401k. Most college savings plans do not charge an early withdrawal fee. Taking out any type of loan is usually preferable. Refinancing a mortgage is another option.

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