Typically, you’re not supposed to take funds out of your 401(k) until you reach retirement age. There are financial penalties associated with early withdrawals and you’ll have less money in the account that can be invested and that can grow. On top of that, you might owe taxes on the withdrawn funds, depending on the type of retirement account you have. Typically, you would avoid taking any funds from your retirement account because then you would have less to live on once you’ve retired.
However, sometimes it’s unavoidable if you have an emergency situation. Before you take a hardship withdrawal from your 401(k), you should talk to your financial advisor to be certain that there isn’t a better option.
What Is a Hardship Withdrawal from a 401(k)?
A hardship withdrawal is an emergency withdrawal of funds from your retirement account. Some 401(k) plan administrators offer hardship withdrawals while others don’t. If you meet the criteria for hardship, then the normal 10% penalty fee that would be applied to an early withdrawal isn’t charged. But what qualifies an early withdrawal as a hardship withdrawal?
What Qualifies as a Hardship Withdrawal?
Whether your early withdrawal can count as a hardship withdrawal depends on why you need to take out the money. The following reasons can count as a hardship withdrawal and wouldn’t incur the 10% penalty:
- Medical expenses (if the costs exceed 7.5% of AGI)
- Permanent disability
- SEPP (substantially equal periodic payments)
- Separation of service
The following reasons count as a hardship but would incur the 10% penalty:
- Tuition and other educational expenses
- Purchase of a home
- Funeral or burial expenses
- Preventing foreclosure or eviction
What Is SEPP?
SEPP, which stands for substantially equal periodic payments, is a way to withdraw from a qualified retirement plan prior to retirement age without incurring the 10% early withdrawal penalty. If you have a SEPP plan, you’ll receive annual distributions of a specified amount from your retirement account, which will stop either after five years or when you reach retirement age, at which point you would start normal distributions rather than continuing with SEPP distributions. To set up SEPP, talk with your financial advisor.
What Is Separation of Service?
Separation of service occurs when you leave your employer in the year in which you would turn the qualified retirement age. Because you would be of a qualifying age to take distributions from your account without the 10% penalty, distributions taken that year even prior to your birthday don’t incur the penalty.
What Is the Difference Between a 401(k) Hardship Withdrawal and a 401(k) loan?
It’s possible to borrow money from your 401(k) for any reason, although it’s not typically recommended unless you have no other option. With a 401(k) loan, you can borrow from your 401(k) and not incur any penalties or pay taxes on the funds as long as you repay the money within a specified period of time. If you don’t pay it back within that time, however, you’ll not only have to pay taxes on it but you’ll also owe the penalty.
By contrast, with a hardship withdrawal, you wouldn’t have such a time limit and also wouldn’t be subject to the penalty, although the funds might be taxable depending on the type of 401(k) you have. With a Roth 401(k), your contributions are taxed as they go into your account and because you’ve already paid the taxes, any distributions for any reason would be tax-free. With a traditional 401(k), however, the contributions were made pre-tax, so you would owe taxes upon distribution.
Additionally, there aren’t any restrictions on the reason for taking out a loan while there are restrictions on what qualifies as a hardship withdrawal.
When Should You Consider Hardship Withdrawals?
Typically, it’s best to not touch the funds in your 401(k) unless you have no other option. If you need funds for education, then a student loan might be a better choice than a hardship withdrawal. Not only would you lose some of the money you’d need for retirement but you would also incur a 10% penalty. If you have emergency medical bills that need to be paid or are on permanent disability, then a hardship withdrawal may be a better idea. No matter what, it’s a good idea to talk to your financial advisor before making any decisions. Plus, applying to take out a hardship withdrawal may need to go through your financial advisor anyway.
