When you have a major expense and you’ve exhausted your financial options, you may turn to your 401K for help. In certain situations, you can make a 401K hardship withdrawal to cover a financial emergency.
401K Withdrawal Rules
The IRS defines a 401K hardship withdrawal as one made because of an “immediate and heavy financial need.” The withdrawal you make must be the amount required to satisfy the need. However, you can withdraw additional funds if they’re used to cover taxes and fees of the 401k withdrawal. You may be able to make a hardship withdrawal for certain expenses even if it was voluntary and you knew the expense was coming.
401k rules state that you can make a hardship withdrawal based on your financial need or the need of your spouse, dependent, or a beneficiary who isn’t your spouse or child.
These types of expenses qualify for a hardship withdrawal:
1. Certain medical expenses.
2. Costs related to the purchase of a first home. These costs don’t include mortgage payments.
3. Tuition, fees, and related education expenses.
4. Payments necessary to prevent eviction or foreclosure on a primary residence.
5. Burial and funeral costs.
6. Certain repairs made to a primary residence.
If you have other ways to meet the need, you must exhaust them before you can make a 401K hardship withdrawal. For example, the IRS considers a vacation home a recourse that could and should be used to satisfy the financial need before taking 401K hardship withdrawal.
You can make the withdrawal after you’ve taken any available distributions and 401k loans from your 401K plan. You won’t be able to make any contributions to your 401K plan for at least six months after you’ve made the hardship withdrawal.
Unless your hardship withdrawal came from a Roth plan, the distribution will be included in your gross income, increasing the amount of income tax you’re liable for. Hardship withdrawals aren’t considered loans and don’t have to be repaid. In fact, the withdrawal can’t be repaid which means the total amount of money in your retirement plan decreases forever.
A 401K withdrawal, even one made because of a financial hardship will be taxed at your regular income tax rate. The amount is also subject to a 10% penalty if it’s taken before you reach age 59 ½. You may be able to waive the 10% early withdrawal penalty if you:
• Are totally and permanently disabled.
• A court orders you to pay money to your spouse, child, or dependent.
• Have medical bills that are more than 7.5% of your adjusted gross income.
• Will be leaving your job in the year you turn 55.
401K Hardship Withdrawal vs. 401K Loan
You may have to take a 401K withdrawal if your plan doesn’t allow 401K loans and vice versa. If you take out a 401k loan, you’ll have to pay it back. You may not be able to make other contributions to your 401K until you’ve completely repaid the loan.
With a hardship withdrawal you can restart your 401K contributions sooner than with a loan. Some 401K hardship withdrawals prohibit you from making contributions for at least six months after the withdrawal, but this is probably less time than if you had to repay a loan.
A 401K loan might be a more attractive choice since you won’t have to pay taxes or early withdrawal on the loan as long as you repay the loan. However, you’ll have to repay the entire loan if you quit your job or are terminated.
If your plan allows 401K loans, you don’t have to meet the financial need qualifications as you do with a hardship withdrawal. You can also borrow beyond your financial need, which you can’t do with a 401K hardship withdrawal.
