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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What Qualifies as “Hardship” for 401k Withdrawals?
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”:
- You have an immediate and heavy financial need that cannot be met by other funds.
- You cannot withdraw more than you actually require to meet this need.
- You must first max out available nontaxable 401k loans and distributions before taking the hardship withdrawal.
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.
What Are Reasons for Taking a 401k Hardship Withdrawal?
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:
- Purchase of your primary residence through a mortgage.
- Payments required to prevent eviction from, or foreclosure on, your primary residence.
- Certain costs that might be related to repairs on a primary residence.
- Medical expenses — not reimbursed — for yourself, a spouse or a dependent.
- College expenses related to tuition, board and room for yourself, your children or your spouse.
- Funeral expenses that you might be required to pay for a loved one.
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.
How Much Money Can You Withdraw?
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.
What are the Advantages of Hardship Withdrawal?
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.
What are the Disadvantages of Hardship Withdrawal?
There are several clear disadvantages to taking out money from your 401(k)
- Taking a hardship withdrawal will reduce the size of your retirement nest egg — possibly causing cash flow problem down the road.
- The funds you withdraw are generally subject to federal and state income tax.
- A 10% federal penalty tax may also apply if you’re under age 59½.
- Note: If you make a hardship withdrawal from your Roth 401(k) contributions, only the earnings portion of the withdrawal will be subject to tax and penalties.
- You may not be able to contribute to your 401(k) plan for six months following a hardship distribution.
Before You Withdraw Your Money from Your 401k
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.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own blog at Miranda Marquit.