We all know that we should not be using our 401k as an emergency fund. However, we all run into unexpected expenses at some time or another, and we might not have the money to pay the costs. If you are experiencing financial hardship and you feel you need to access the money in your 401(k), you can either borrow money from you 401(k) plan or utilize a hardship withdrawal (which is the topic of discussion for this article) — but before you do, you should know what it is and the pros and cons.
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It is important to note that not all plans provide the option for hardship withdrawals. Your 401k plan may not have this option, so you should check with your employer to find out whether you can even withdraw money in hardship. Next, you have to understand that the IRS is very specific about hardship withdrawals, and how they can be taken. Here are some of the guidelines related to what constitutes “hardship”:
It is also important to understand that you will be ineligible to contribute to your 401k for at least six months after the withdrawal. Understand that the 10% early withdrawal penalty still applies if you are not 59 1/2, and that you will have to pay income tax on the amount that you withdraw.
Not only do you have to meet the conditions above, but you also need to make sure that the expenses you are withdrawing the money for fall into one of six categories recognized by the IRS as acceptable reasons for a hardship withdrawal. These items include:
When you take a hardship withdrawal, you might be providing yourself with a little breathing room. However, it is important to carefully consider your options before going through with the hardship withdrawal from your 401k.
The amount will depends on the plan, so it is best to check with your plan administrator for more information on the rules that apply to withdrawals from your 401(k) plan. Generally, you can’t withdraw more than the total amount you’ve contributed to the plan, minus the amount of any previous hardship withdrawals you’ve made. In some cases, you may be limited to withdrawing only the earnings on contributions you’ve made.
The option to take a hardship withdrawal can come in handy if your plan does not allow loans or if you can’t afford to make loan payments.
There are several clear disadvantages to taking out money from your 401(k)
As tempting as it is to withdraw money from your 401k, it is important to take a step back and consider your options. A hardship withdrawal doesn’t have to be paid back, but you are missing out on opportunities when you remove that money. It is gone from your account, and you can no longer count on it to work on your behalf, building up wealth.
Additionally, that 10% penalty can be quite significant, and you might find yourself in even bigger trouble come tax time if your hardship withdrawal bumped you into the next tax bracket. Before pulling out the money, make sure that your immediate need is great enough to justify the penalties, taxes and costs of lost opportunity.