What are hardship criteria?
If your 401(k) plan allows hardship withdrawals, it will be for one of the following seven reasons:
1. Certain medical expenses.
2. Costs related to the purchase of a primary residence. (In other words, you cannot take hardship withdrawals to buy an investment property or vacation home.)
3. Tuition and related education expenses.
4. Payments necessary to prevent eviction from your primary home or bankruptcy proceedings.
5. Funeral or burial expenses.
6. Costs for repairing damage to your home.
7. Expenses including lost income incurred if you live in a FEMA-recognized disaster area.
Taxes affecting 401(k) hardship withdrawals
You will pay taxes on the amount you withdraw as a hardship withdrawal. In addition to regular income tax, you may also incur a 10% penalty. You may be able to avoid the 10% penalty if you meet one of the following exceptions:
1. You are disabled. Your medical debts exceed 7.5% (or 10% after 2012 if you are under age 65) of your adjusted gross income. You are required by a court order to pay money to your ex-spouse or to a child or other dependent.
Hardship documentation
To qualify as a hardship, you will need to present your case to your 401(k) plan administrator. Most often, they can determine if your circumstances meet the hardship criteria. Some 401(k) plans may require you to submit a documentation form. Ask your 401(k) plan provider about the documentation required as proof of hardship.
Before taking a hardship withdrawal
Many people do not realize that 401(k) funds are protected from creditors and are shielded from bankruptcy. If you are facing financial difficulties and think you may end up filing for bankruptcy, do not withdraw your 401(k) plan funds. Your creditors cannot take your 401(k) plan funds. It may be better to borrow money rather than take a 401(k) hardship withdrawal. Many people withdraw money from their 401(k) plan or take hardships to pay medical expenses when their 401(k) funds are protected. Try to come up with a repayment plan before touching your 401(k) funds.
After taking a 401(k) hardship withdrawal
Under prior law, for six months after taking a 401(k) hardship withdrawal, you were not allowed to contribute to your 401(k) plan. This six-month period was eliminated as of January 1, 2020. You are not allowed to repay the hardship withdrawal amount, but you can continue to contribute up to the maximum allowed for your 401(k) plan for that year.
Can you take a hardship withdrawal from an IRA?
IRA owners are not allowed to take hardship withdrawals from an IRA – at least, not in that way. As an IRA owner, you can withdraw money at any time, but you will incur a 10% penalty if you are under age 59 1/2. There is an exception to this rule: you can withdraw money from your IRA for certain specific educational expenses or to purchase your first home.
401(k) hardship withdrawal vs. 401(k) loan
When you borrow money from your 401(k) plan, you can repay it over five years. The interest you pay goes back to your account. At the time you take a loan from your 401(k) plan, you will not pay taxes on the amount you borrow if the loan meets certain criteria.
Avoid hardship withdrawals if possible
A hardship is just that – a hardship. It will not be something you planned for. Often, it will be an emergency or difficult situation, and you may be out of options, but if there are other choices, exhaust them first.
Many Americans are behind on retirement savings and face severe financial shortages when they can no longer work. Withdrawing money from your retirement savings before retirement may solve your current problem, but it can create or exacerbate a future issue that may be harder to solve.
Before
If you take a hardship withdrawal, talk to a financial advisor and explore all other options available to you.
Frequently Asked Questions (FAQs)
What are the consequences of a hardship withdrawal?
It was common for employers to prevent you from making any contributions to that account or another account after a hardship withdrawal. This is no longer allowed, effective January 1, 2020. A withdrawal from a 401(k) plan is subject to taxes and is included in your total income, resulting in paying additional taxes when you file your next return. Additionally, the amount is not repaid as it would be in the case of a loan, so you permanently lose this amount from your retirement savings if you take an early withdrawal.
What is the difference between a hardship withdrawal and a 401(k) loan?
Hardship withdrawals are allowed when there is an immediate and urgent need. The amount in these withdrawals is based on how much you need for the financial situation, and it will be taxed by the IRS. 401(k) loans are better in situations where the financial need is not urgent. You will be able to borrow half of what is in your account, but you will be obligated to pay it back.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
Source: IRS. “Retirement Topics – Hardship Distributions.” IRS. “Retirement Topics – Tax Exceptions for Early Distributions.” IRS. “Questions and Answers about Retirement Plans and Hardship Distributions.” Legal Information Institute. “11 U.S. Code § 522. Exemptions.” IRS. “Questions and Answers about Retirement Plans and Hardship Distributions.” IRS. “401(k) Resource Guide – Plan Participants – General Distribution Rules.” IRS. “Questions and Answers about Retirement Plans and Hardship Distributions.”
Source: https://www.thebalancemoney.com/what-to-know-before-taking-a-401-k-hardship-withdrawal-2388214
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