Everything You Need To Know About The 401k Hardship Rules
If you urgently need cash in an emergency, you may be able to make a ‘hardship withdrawal’ from your 401k plan.
However, there are strict rules for making such a withdrawal and it is likely to come at a heavy cost. It is therefore vital that you understand the implications before dipping into your retirement fund. Keep reading to learn more.
When you can make a withdrawal
A 401k withdrawal is not like a loan from your plan. It may be difficult to obtain and it is likely to cost you a significant amount.
However, Congress did make provision in the rules for 401k plans to let plan holders access their savings in extreme circumstances. The rules don’t allow you to take money simply because you’re inconvenienced and you have to prove that you truly need the cash. Such reasons include:
- Funeral expenses
- The purchase of a main residence
- To pay for medical expenses for you, your spouse or your dependents
- Payment of college tuition and related educational costs for the next 12 months for you, your spouse, dependents, or children who are no longer dependents
- Payments necessary to prevent foreclosure or eviction from your home
- Certain expenses to pay for damage repairs to your private residence
Hardship withdrawal penalties
To discourage you from dipping into your retirement fund, there are significant penalties when you make a hardship withdrawal.
If you are younger than 59 ½, any money that you withdraw is subject to the appropriate income taxes and you will also pay a 10 per cent ‘early withdrawal penalty’. This means you could lose around 30-40 per cent of your withdrawal in taxes and penalties.
However, you may qualify for a ‘penalty free’ withdrawal if:
- A court requires you to give money to your divorced souse, a child or a dependent
- You become totally disabled
- You are separated from service (through resigning, permanent layoff, termination or early retirement) in the year that you turn 55 or later
- You owe medical expenses that are more than 7.5 per cent of your adjusted gross income
You will still pay the applicable income taxes on withdrawals under the above circumstances.
Keep in mind also that your employer does not have to offer the ability to make a hardship withdrawal. You should therefore check that such a withdrawal is available to you.
Avoiding hardship withdrawals
If possible, you should consider other alternatives before you dip into your 401k plan. The hardship rules will also normally require you to exhaust all other options before withdrawing from your plan.
For example, you may want to consider a 401k loan or the withdrawal of after-tax savings.
You should also remember that your 401k plan is designed to provide you with an income in retirement. Withdrawing from your plan early will reduce the amount of savings you have available and reduce your income when you retire. This is particularly true if you make a withdrawal at an early age as you’ll lose both the amount you withdraw and any potential growth on that money.
If I need to make a withdrawal from my 401k plan, do I have to tell my employer why?
Leyton – thanks for your question. If you want to restart contributing to your 401k plan immediately then yes, you may have to show your employer proof that you need the money.
Alternatively, the ‘self certification’ method doesn’t require you to divulge your finances but it also means you can’t make any 401k contributions for a six month period.