Understanding hardship withdrawals from your 401(k)

401(k) hardship withdrawals are designed to cover emergency expenses. According to the IRS, a hardship withdrawal is a distribution due to an "immediate and heavy financial” need. The primary reason for a hardship withdrawal is generally emergency medical expenses. However, mortgage payments and tuition payments may count as valid reasons, as well as the needs of spouses and dependents, as they pertain to the reasons listed above.

A hardship withdrawal from your 401(k) may be an option to consider if you need a significant amount of money that you can’t otherwise repay. You should carefully consider your options before making a withdrawal from your 401(k) before retirement, however. The withdrawal amount is restricted to the amount necessary to cover the financial need, including any penalties and taxes you will need to pay on the withdrawal itself. 

It's important to note that a 401(k) distribution will be taxed as regular income the year it’s taken. This article reviews the eligibility of qualifying for a hardship withdrawal, the tax implications of taking one, and the rules surrounding this type of 401(k) withdrawal. Refer to our article on 401(k) withdrawal rules to review the general rules of withdrawals and what can happen if you decide to take out money from your account.

How to make a 401(k) hardship withdrawal

Every 401(k) plan is different. Many, but not all, 401(k) plans offer the option for participants to withdraw money in the case of financial hardship. 

Plans require documentation of a hardship circumstance. This typically involves showing your employer financial proof that you need the money. The documentation you must provide will depend on the hardship situation. Some employers or third-party administrators may allow you to self-certify, which requires you to maintain the documentation for several years for audit purposes instead of providing proof at the time of distribution.

Eligibility for a hardship withdrawal

According to the Internal Revenue Service (IRS), to qualify for an emergency or hardship withdrawal from your 401(k), the “immediate and heavy financial need” stipulation applies to the needs of an employee, but can also accommodate their dependents, including a spouse. Your plan document will outline the specific requirements needed to be met in order to receive a hardship withdrawal.

It’s important to note that some plans may allow hardships based upon facts and circumstances, which accounts for broader situations than the IRS “safe harbor” but also increases the risk of ineligible hardship withdrawals. Therefore, most plans provide for qualifying hardships based upon IRS “safe harbor” rules, which set out clear guidance for the following hardship situations: 

• Medical expenses: Costs for medical care for the employee, their spouse, or dependents.

• Purchase of a principal residence: Expenses directly related to the purchase of the employee's principal residence, excluding mortgage payments.

• Tuition and related educational fees: Tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee, their spouse, or dependents.

• Prevention of eviction or foreclosure: Payments necessary to prevent eviction from the employee's principal residence or foreclosure on the mortgage on that residence.

• Funeral expenses: Costs associated with the funeral or burial of the employee's deceased parent, spouse, children, or dependents.

• Repairs to your principal residence under specific circumstances (damages from normal wear and tear or progressive deterioration do not qualify as casualty losses; damages must result from an event that is unusual, sudden, or unexpected).

To qualify for a hardship withdrawal, you must exhaust all other means of assistance. This includes in-service withdrawals allowed from your plan. Most plans allow in-service withdrawals from a rollover source at any time, and many plans allow for in-service withdrawals upon attainment of age 59 ½ or later. Your Plan Administrator will require you to make all available withdrawals before allowing you to request a hardship distribution.

Additionally, keep in mind that hardship rules are only relevant for your 401(k) with your current employer. The hardship rules do not apply once you have been separated from the employer, whether through resignation, retirement, permanent layoff, or termination.

401(k) hardship withdrawal rules: How much you can withdraw

In addition to meeting the eligibility requirements to access a hardship withdrawal, there are also limits to how much you can withdraw. You are only allowed to withdraw the amount necessary to cover your financial needs, including any penalties and taxes you will need to pay on the withdrawal itself.

Your plan document may limit the sources available to you for a hardship withdrawal. See your plan document for specific restrictions that may apply. 

Tax rates for 401(k) withdrawal

A hardship withdrawal is considered taxable income in the year it is distributed. This means you must still pay taxes on the amount you withdraw from your retirement account. Hardships are ineligible for rollover. This means the distribution is subject to optional 10% federal withholding, but you may adjust your withholding as you see fit by submitting a Form W-4R to your plan administrator at the time of distribution. In addition, state taxes will apply based on the state in which you reside. In addition, you may be subject to a 10% additional early distribution tax. 

What hardship withdrawals may cost

Electing to take a hardship withdrawal could hurt your long-term retirement savings goals since you are removing part of your accumulated savings, as well as future appreciation to that sum.

You will be required to pay income tax on the amount of the hardship withdrawal. The income tax will be at your current rate, which means it could be higher than the taxes you would pay on the funds if you withdrew them after retirement.

Alternative ways to access 401(k) funds

If you are able to repay a loan in a timely manner (i.e., within five years), it might be worthwhile to consider a loan instead of a withdrawal. You can also opt for a loan from your 401(k) for the lesser half of your account balance or $50,000. However, such loans must be repaid with interest, although that interest will ultimately be returned to your account. The loan will convert to a withdrawal if you default on payments. This is accompanied by many of the same consequences as taking out a hardship withdrawal to begin with.

If you are looking for a low-cost, full-service 401(k) for your small or medium business, consider Human Interest. We offer 401(k) plans that come with affordable and transparent pricing and are easy to use. We also provide automated administrative aspects, including enrollment and payroll sync.