LAST REVIEWED Apr 14 2020 9 MIN READ
By The Human Interest Team
401(k) hardship withdrawals are designed to cover emergency expenses. The primary reason for a hardship withdrawal is generally for emergency medical expense. however, mortgage payments and tuition payments may count as valid reasons as well. Additionally, the needs of spouses and dependents, as they pertain to the reasons listed above, may be covered.
Ultimately, however, it's important this 401(k) distribution will be taxed as regular income. This article reviews when you may qualify for a 401(k) hardship withdrawal and the tax implications of taking one.
How to make a 401(k) hardship withdrawal
A hardship withdrawal from your 401(k) with your employer 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.
Tax rates for 401(k) withdrawal
It's very difficult to make withdrawals from your 401(k) without the hardship provision if you are under 60 years old. With a hardship withdrawal, you must still pay taxes on the amount you withdraw from the account. However, unlike a 401(k) loan, you do not need to repay the funds at any point. For certain qualified expenses, such as the presence of a disability or expenses like medical bills, a hardship withdrawal can give you access to your retirement funds without penalty.
According to the IRS, hardship distributions may be subject to income taxes (unless they're Roth contributions) and may be subject to a 10% additional early distribution tax. If you take a hardship distribution, you aren't able to:
Repay it to the plan
Roll it over to another plan or an IRA
(Note: In April 2020, an exception for withdrawals was created for individuals affected by coronavirus. See more here.)
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 his or her dependents, including a spouse or beneficiary.
Note that every plan is different. Your 401(k) plan’s administrator can help you determine whether your circumstances can qualify as a hardship. Some plans may also require documentation of a hardship circumstance. This typically involves showing your employer financial proof that you need the money. If you’d rather not show your finances, you can self-certify.
Repairs to your principal residence may also make you eligible for a hardship withdrawal, under specific circumstances. Damages to your residence from normal wear and tear or progressive deterioration do not qualify as casualty losses. To qualify, the damage to your residence must result from an event that is unusual, sudden, or unexpected.
Reforms that passed in 2018 as part of the Bipartisan Budget Act eliminated the requirement that a recipient needed to take a loan from his or her plan before you are able to apply for a hardship withdrawal.
Regardless of these reforms, however, your plan administrator (most often your employer) is still in charge of making the final decision as to whether you may take a hardship withdrawal. According to the IRS, administrators are not required to provide the option for a hardship distribution along with a retirement plan.
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.
While you get to keep your finances private in that case, you can’t make any more contributions to your 401(k) for six months after making the withdrawal. Of course, the qualifications and whether or not hardship withdrawals are even allowed in the first place will vary from company to company.
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 must withdraw the amount necessary to cover your financial need, including any penalties and taxes you will need to pay on the withdrawal itself.
Under the old rules for hardship withdrawals, employees were only allowed to withdraw their own salary-deferral contributions or amounts that they had elected to withhold from their paycheck. However, with the recent reforms, the maximum amount you can withdraw represents a larger proportion of your 401(k) plan.
Historically, if you took a hardship withdrawal, you would not be able to make new contributions to your 401(k) for six months. However, that requirement is eliminated effective January 1, 2020.
If your employer allows it, you may be able to withdraw investment earnings in addition to your employer’s contributions under the reformed rules. You can also continue to contribute to your retirement account, so you may still be eligible to receive any matching contributions from your employer, and you will not fall as far behind on your retirement savings goals.
What Hardship Withdrawals Will Cost You
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.
If you are younger than 59 1/2 years old, you will be subject to an additional penalty of 10%. However, there are certain exceptions that you may qualify for, including:
You are receiving funds via a corrective distribution.
You owe income tax on the money.
You suffer from total and permanent disability.
You have medical expenses in excess of 10% of adjusted gross income (AGI).
Other Options for Getting 401(k) Money
You may be able to withdraw funds from your 401(k) whether or not you suffer from a qualifying hardship if you are older than 59 1/2 years old.
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.
The majority of 401(k)s permit in-service, non-hardship withdrawals as well. However, these funds must be transferred to another investment option, so it does not provide assistance if you have a pressing need.
Before Taking a Hardship Withdrawal
It is important to know that your 401(k) account is protected from creditors and in the case of bankruptcy. This means you should not cash out your 401(k) if you are likely to file for bankruptcy due to financial hardship.
If you are looking for a low-cost, full-service 401(k) for your small or medium business, look no further than Human Interest. We offer 401(k) plans that are easy to use and understand, come with affordable and transparent pricing, and are supported by a dedicated account management team. We also provide automated administrative aspects, including enrollment and payroll sync.
Visit our site to schedule a chat with our team and get started on investing in your employees’ financial futures today.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.