When Should you Consider a 401(k) Hardship Withdrawal?

When Should you Consider a 401(k) Hardship Withdrawal?

Kim Pinnelli

by Kim Pinnelli
Senior Contributing Writer

January 8, 2020
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When Should you Consider a 401(k) Hardship Withdrawal?

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You may be eligible or a 401(k) hardship withdrawal, but it comes with its own penalties and expenses, making it a more expensive choice than many realize.

What happens if you find yourself in a bind and need access to funds you’ve contributed to your 401(k)? Is it tied up until retirement or will you qualify for an early 401(k) withdrawal?

What Qualifies as a Hardship?

First, you need to know what qualifies as a hardship for an early 401(k) withdrawal. While each situation will differ, the most common reasons include:

  • Medical expenses (if they exceed 7.5% of your adjusted gross income)
  • Buying a home
  • Paying for college
  • Funeral costs
  • Home repairs (emergency)

Each plan will have different allowances that qualify as a hardship.

What is the Penalty for early withdrawals?

Withdrawing your 401(k) funds early comes with plenty of penalties and taxes. First, you’ll pay ordinary taxes on the withdrawal since you didn’t pay taxes when you contributed the funds. Normally, you’d wait until retirement to pay the taxes, but withdrawing them now means paying taxes now.

On top of regular taxes, though, you may also be subject to a 10% early withdrawal tax and a 10% penalty. On average, you’ll lose about 30% of the amount you withdraw to taxes and penalties.

When do Penalties not Apply?

In some cases, you may be able to avoid the 10% penalty. This may apply if you:

  • Become disabled
  • Your medical expenses exceed 7.5% of your adjusted gross income
  • You have a court order to pay your ex-spouse in a divorce

In all other cases, while you can have access to your funds, you’ll pay a 10% penalty on amounts you withdraw. For example, if you withdraw $5,000, right off the bat, you’ll owe $500 as a penalty, plus the amount you owe in taxes.

How Much can you Withdraw?

Just because you contributed the money in your 401(k) account doesn’t mean you can withdraw any amount you like. Each plan has its own maximums, but in general, you may only withdraw the amount that you can prove is required to settle the issue. In other words, it must be just enough to cover the financial need, plus the cost of penalties and taxes.

The latest rules for an early 401(k) withdrawal do allow you to withdraw not only your own contributions, but those your employer contributed as well. This will vary by plan, of course, but it’s an option that may be available to you.

How are Taxes Handled?

Most plan administrators will automatically deduct 20% for taxes in an early withdrawal. They send the payment directly to the IRS. You then claim that payment on your tax returns when you file taxes. If there was an overpayment, it will reflect in your refund or in your lower tax liability if you owe in other aspects of your income.

How Long Does it Take to Get Your Funds?

Once you initiate a 401(k) early withdrawal, it can take between one to two weeks to receive your funds. The exact time depends on the administrator. If you plan to apply for a hardship withdrawal, ask your administrator about the timeframe.

What’s the Difference in a 401(k) Loan and 401(k) Withdrawal?

If you don’t qualify for an early 401(k) hardship withdrawal, you may be eligible for a 401(k) loan. While these two options have similarities, there are differences too.

As the name suggests, a 401(k) loan means that you borrow money from your 401(k). In other words, you’ll need to pay it back. In order to qualify for a 401(k) loan, you must:

  • Apply for the loan
  • You may not borrow more than the lesser of $50,000 or 50% of your vested balance
  • Prove that you can repay the loan

Typically, you have five years to pay back the loan, but the terms may differ by plan. In fact, some plans may not even allow the option to take out a 401(k) loan. You don’t pay an early withdrawal penalty (10%) or taxes on the loan funds because the IRS doesn’t consider the funds income since you have to pay them back. However, if you don’t pay the funds back within the allotted time (max is 5 years), you will be subject to the 10% early withdrawal penalty and income taxes.

The hardship withdrawal is somewhat similar in that you take funds out of your 401(k) early, but you don’t pay the funds back. Instead, you must pass the ‘immediate and heavy need’ test to prove that you do need the funds and that you don’t have any other funds that could satisfy the need.

Unlike the 401(k) loan, you may only withdraw as much as is needed to satisfy the financial need. In other words, you can’t just withdraw as much as you want up to the 50% maximum, like a loan. In addition, you must prove that the financial need is ‘sudden.’ It doesn’t necessarily have to be an ‘unforeseen’ incident, but that is up to each plan administrator.

The main difference between an early withdrawal and a 401(k) loan is the need to share your reason. If you take out a 401(k) loan, you don’t have to give a reason. Each plan administrator may have their own rules, but in general, they don’t need to approve the reason. With an early withdrawal, however, there are strict stipulations that determine if you can take the early withdrawal.

You can only use the early 401(k) withdrawal in certain circumstances. It’s best to exhaust all other options before choosing this option because it affects your retirement income and decreases the amount of interest compounding you have, which decreases your retirement income even more. If you have an immediate need for funds, exhaust options for an unsecured loan, family/friend loan, or even a home equity loan before tapping into your 401(k).