Crucial Facts to Understand About 401(k) Hardship Loans

If you are experiencing an “immediate and substantial financial need,” the IRS may grant permission for a 401(k) hardship withdrawal. When facing financial difficulties, you may have contemplated tapping into your 401(k) plan for assistance. While there are situations in which current employees can make 401(k) withdrawals, certain conditions must be met to avoid penalties associated with early withdrawals from your retirement account.

To gain insight into the process of obtaining a 401(k) hardship withdrawal, consider the following:

What Constitutes a 401(k) Hardship Withdrawal?

A hardship withdrawal entails accessing funds from a retirement account before reaching the eligible withdrawal age. 401(k) plans typically allow withdrawals starting at age 59 1/2. Those who withdraw funds before this age usually face a 10% penalty and income tax on the withdrawn amount. However, some plans permit early withdrawals for individuals in dire circumstances, provided certain requirements are met, thus exempting them from the 10% penalty.

Reasons for a 401(k) Hardship Withdrawal

The Internal Revenue Service permits a 401(k) hardship withdrawal when there is an “immediate and substantial financial need.” In such cases, the 10% penalty may be waived. The IRS identifies the following situations that might qualify for a 401(k) hardship withdrawal:

  • Certain medical expenses.
  • Funeral or burial costs.
  • Expenses related to purchasing a primary residence.
  • College tuition and educational expenses for the upcoming 12 months.
  • Costs necessary to prevent foreclosure or eviction.
  • Home repairs following a natural disaster.

Employers establish the criteria for hardship withdrawals when setting up their employees’ 401(k) plans. Some employers may require employees to exhaust loan options before applying for a hardship withdrawal.

401(k) Hardship Withdrawal Rules

Before proceeding with a withdrawal, check whether your 401(k) plan offers the option of hardship withdrawals. Not all plans grant this option. Remember that the decision to permit hardship withdrawals rests with the plan sponsor. To be eligible for a withdrawal, you must demonstrate a lack of available funds to cover the expenses.

A qualifying financial need does not necessarily have to be unexpected. Even expenses that were planned or voluntary may be deemed immediate and substantial. However, many expenses, such as luxury purchases like boats or televisions, typically do not qualify for a hardship distribution.

401(k) Hardship Withdrawal Limits

For those meeting the criteria for a 401(k) hardship withdrawal, the next step is determining the allowable withdrawal amount. In most cases, you can withdraw only what you need. For example, if earthquake-related house repairs cost $10,000, you cannot withdraw more than that. Additional funds may be permitted to cover related expenses, such as taxes on the transaction.

Remember that a hardship withdrawal incurs income tax, and if you are under the required age of 59 1/2 years old, you may also face a 10% early withdrawal penalty. Repaying the plan or rolling over funds into another account, such as an IRA, is not an option in this scenario.

401(k) Hardship Withdrawal Documentation

To access the funds, you must contact your plan sponsor, who may be a human resources representative or a designated financial advisor. This is where you can learn about your employer’s requirements and obtain the necessary paperwork to initiate the hardship withdrawal. The application process may be either paper-based or online.

Consequences of Taking a 401(k) Hardship Withdrawal

Withdrawing funds from your 401(k) for a hardship and using them will result in the loss of both the saved amount and potential interest that could have accumulated for retirement. Every dollar withdrawn early from your 401(k) reduces your retirement savings and the long-term growth potential on a tax-deferred basis.

Purchasing a home for personal residence purposes may have a relatively less negative impact, as homes tend to appreciate over time, akin to investments. However, other forms of spending may not provide similar benefits.

Funds within a qualified retirement plan are typically safeguarded from creditors. Still, when withdrawn from a 401(k), they may become susceptible to claims. Therefore, if you are considering personal bankruptcy or anticipate being unable to make payments for an extended period, retaining your funds in the 401(k) may be advisable.

Alternatives to a 401(k) Hardship Withdrawal

Instead of withdrawing, consider exploring the possibility of a 401(k) loan. These loans are typically limited in amount and must be repaid over a specific period, often less than five years, along with interest. If you leave your job before repaying the loan, the balance may be treated as a withdrawal, subject to income taxes and penalties if you are under 59 1/2 years old.

Individuals over 59 1/2 years old may be able to take penalty-free distributions from their 401(k) accounts. Additionally, early retirees may be eligible for penalty-free distributions at age 55, while this age requirement drops to 50 for retired public safety professionals, such as police officers and firefighters.