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Sunday, April 21, 2024

How a 401(k) hardship withdrawal works

How a 401(k) hardship withdrawal works

02.01.2023

We all know that 401(k) accounts are meant for retirement savings. But we also all know that once in a blue moon, a situation arises — a big unexpected medical bill, or a down payment on a home — where we wish we could tap some of those funds in our 401(k).

Before we dive in, I’m going to say this right upfront: it’s never a good idea to take money from your retirement fund if you can help it. Early withdrawals can carry hefty penalties and taxation, and you can rob yourself of the power of compounding earnings if you take funds out of your 401(k) that could otherwise potentially be growing.

If you do find yourself in a situation where it’s unavoidable to withdraw funds from your 401(k) early, there is something called a 401(k) hardship withdrawal that might allow you to access your contributions.

It’s up to the plan sponsor to decide whether to allow hardship withdrawals from the plan; however, most 401(k) plans do allow participants to make these kinds of withdrawals.

What is a hardship withdrawal?

As the name implies, 401(k) hardship withdrawals are designed to let participants withdraw money from their retirement plans if they’re facing certain financial hardships. But the IRS’ definition of hardship is rather broad. Hardship withdrawals are currently allowed for one of the following reasons:

  • Medical expenses incurred by the participant or the participant’s spouse, dependents or beneficiaries.
  • The purchase of a home if the home will serve as a primary residence, not an investment property.
  • To prevent eviction from or foreclosure on a primary residence.
  • Funeral expenses for the participant or the participant’s spouse, dependents or beneficiaries.
  • Tuition and related expenses (such as fees and room and board) for the next year of post-secondary education for the participant or the participant’s spouse, dependents or beneficiaries.
  • Expenses that are necessary to repair damage to the participant’s primary residence that would qualify for a casualty deduction.

Empower research shows that new hardship withdrawals stacked up to $9,926 in 2023. More than a quarter of surveyed Americans say they are very likely (10%) or somewhat likely (17%) to take out a loan or hardship withdrawal in the next six months.

Drawbacks of making hardship withdrawals

Keep in mind that just because you are facing one of these financial hardships doesn’t mean that taking out a hardship withdrawal is the best financial move. There are several potential drawbacks to making hardship withdrawals.

Perhaps the biggest disadvantage is that regular income taxes will be due on the funds taken out during the year in which they’re withdrawn. And if you’re under age 59½, a 10% early withdrawal penalty may also apply. There are a few exceptions to the early withdrawal penalty, including medical debt that exceeds 7.5% of your adjusted gross income (AGI).

If you don’t qualify for one of these exceptions and you are under 59½, you could receive significantly less money than the amount you take out via a hardship withdrawal. For example, if you’re in the 22% tax bracket and make a hardship withdrawal of $10,000, you’ll only retain $6,800 after subtracting $3,200 in taxes and penalties.

Another big drawback to making hardship withdrawals is that this could jeopardize your ability to enjoy a financially comfortable retirement. Every dollar withdrawn from your 401(k) early is a dollar that isn’t there for retirement. In addition, you lose the opportunity for these funds to grow on a tax-deferred basis over the long term, which could potentially grow your nest egg even more.

Our take: A last resort financing option

In most instances, 401(k) hardship withdrawals should be considered a last resort for obtaining funds, even if a particular situation qualifies as a hardship. The taxes and penalties associated with hardship withdrawals and the impact such withdrawals may have on your retirement finances can make them an expensive source of funds.

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Kyle Ryan

Contributor

Kyle Ryan is the Executive Vice President, Personal Wealth Advisory at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he is responsible for delivering an industry leading asset growth and retention wealth management client experience.

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