401(k) Hardship Withdrawal: What It Is, How It Works & When to Use It

If you are short on funds to deal with an emergency, you may have considered withdrawing from your 401(k). You must know that you cannot simply make a withdrawal from your 401(k) anytime you’d like.

A 401(k) retirement account is typically designed to allow you to withdraw at age 59½. If you take a distribution before that age, you are slapped with a 10% penalty, plus income tax on the amount withdrawn.

That being said, there are several specific circumstances when you can take 401(k) withdrawals to cover emergency costs. These exceptions are called 401(K) hardship withdrawals.

This post is here to explain what a 401(K) hardship withdrawal is, its pros and cons, and whether tapping into 401(k) early may be worth considering.

What Is a 401(k) Hardship Withdrawal?

A 401(k) hardship withdrawal is a one-time distribution from your retirement account to cover an immediate and heavy financial need approved by the IRS. You can withdraw only the amount necessary to meet the hardship, including any applicable taxes.

Although some hardship withdrawals may qualify for penalty exceptions, most are still subject to income tax, and the withdrawn amount cannot be repaid to your 401(k).

How Does a 401(k) Hardship Withdrawal Work?

To take a hardship withdrawal, you must:

• Demonstrate an immediate and heavy financial need
• Withdraw only what is required to cover the expense
• Follow your employer’s 401(k) plan rules
• Provide documentation, if requested

What Qualifies as a 401(k) Hardship Withdrawal?

The IRS defines specific situations that may qualify as a 401(k) hardship withdrawal, including:

• Burial or funeral costs for a deceased spouse, dependent, or beneficiary.
• Costs for purchasing a principal residence.
• Certain medical expenses (as defined in IRC Section 213 (d)).
• Post-secondary education fees, tuition, room, and board for the next 12 months for you or your dependents.
• Home repairs after a natural disaster.
• Expenses to prevent foreclosure or eviction.

How Much Can You Withdraw as a 401 (K) Hardship Withdrawal?

Different plans often have specific limits in place for hardship withdrawal, both minimum and maximum. These rules help ensure you are only withdrawing what’s necessary to cover your financial needs. Here’s a quick look at how much you might be able to take out.

• Minimum Withdrawal

  Your plan may enforce a minimum, typically $1,000, to justify the processing cost.

• Maximum Withdrawal

  You can pull up to 94% of your vested account balance to meet your needs, plus taxes and penalties. Some plans allow distributions only from your contributions, while others let you access employer contributions and earnings too.

401(k) Hardship Withdrawal Rules

Not all 401(k) plans allow hardship withdrawals. When employers set up the 401(k) plan for their employees, they also set the requirements for hardship withdrawals. So, it’s up to your employer and the plan custodian to approve your request. Unlike a 401(k) loan, you cannot repay a hardship withdrawal.

Taxes Affecting a 401(k) Hardship Withdrawal

401(k) hardship withdrawals are taxed as ordinary income. And if you are under age 59½, there is a penalty of 10% applied if you don’t qualify for an exception. If you are under 59½, you can avoid the 10% penalty if

• You are disabled
• Your medical expenses are higher than 7.5% of your adjusted gross income
• You are required by a court order to give the money to a child, dependent, or ex-spouse.

401(k) Hardship Withdrawal Limits

If you meet the criteria to qualify for a 401(k) hardship withdrawal, you need to determine how much money you can withdraw. In most cases, you are allowed to withdraw only what you need.

For example, if your home repair cost after an earthquake is $15,000, you wouldn’t be able to withdraw more than that. However, you may be allowed to take additional funds to cover related costs, such as taxes on the withdrawal transaction.

In 2020, the CARES Act allowed individuals to withdraw up to $100,000 to cover COVID-related costs without the 10% early withdrawal penalty. The act also allowed for tax payments over three years.

How to Avail Hardship Withdrawals From Your 401(k)

Taking a hardship withdrawal from your 401(k) isn’t automatic. You need to follow a specific process. From contacting your plan sponsor to submitting documentation and getting approval, here are the typical steps.

• Talk to Your Plan Sponsor

  Your plan sponsor could be a human resources representative at your company or a financial advisor assigned to the plan. You can contact them to find out if you are eligible and provide the paperwork needed for a hardship withdrawal.

• Provide Proof of Hardship

  In some cases, your 401(k) plan provider might ask for proof of hardship, which can include financial statements, a notarized statement from an accountant, or an eviction notice.

• Get Approved for the Withdrawal

  Once your documents are verified, your plan administrator gives you the approval to make a hardship withdrawal.

What Are Your Non-Penalty Withdrawal Options?

While hardship withdrawal is one way to access your 401(k) early, there are several other scenarios where you can tap into your retirement funds without triggering the 10% early withdrawal penalty. They are

• Unreimbursed Medical Expenses

  If your out-of-pocket medical bills exceed 7.5% of your adjusted gross income (AGI), you may qualify for an early, penalty-free withdrawal to cover those costs.

• Terminal Illness Diagnosis

  Individuals diagnosed with a terminal condition may be eligible for early withdrawals without facing the standard penalty.

• Purchasing Your First Home

  If you are a first-time homebuyer, you can withdraw up to $10,000 from certain retirement accounts, such as IRAs, without penalty. This doesn’t apply to 401(k) directly but can be done through rollovers.

• Disaster Relief Withdrawals

  If a federally declared disaster impacts you, you may be able to withdraw up to $22,000 without the early withdrawal penalty.

• IRS-Approved Exceptions

  The IRS provides a list of qualifying exceptions that waive the early withdrawal penalty in specific circumstances. Always refer to the latest IRS guidelines or consult a tax advisor for clarity.

Things You Should Know About Hardship Withdrawals

Before you decide to make a hardship withdrawal, there are a few things you need to consider

• You Lose Protection From Creditors

  Your 401(k) money is protected from creditors and bankruptcy. If you are having financial hardship and are close to filing for bankruptcy, don’t cash out your 401(k). Your creditor cannot seize the money in your 401(k). In this case, it’s better to borrow money from other alternatives than make a hardship withdrawal.

• You Can Continue Making Contributions to Your 401(k)

  Prior laws didn’t allow you to make contributions to your 410(k) for six months if you made a 401(k) hardship withdrawal. Since January 1, 2020, this six-month pause has been eliminated. Although you are not allowed to repay the withdrawal amount, you can continue contributing up to the maximum 401(k) allowable contribution limit for the year.

• It’s a Loss to Your Retirement Goals

  Since the amount withdrawn during a hardship withdrawal cannot be repaid to the account, you lose out on the saved amount and the associated interest that would have been accumulated over the years had you left the amount in the account.

• You Can’t Make Hardship Withdrawals From IRAs, at Least Not How it is Done With a 401(k)

  With an IRA, you can withdraw money at any time, but you have to pay a 10% penalty if you are not 59½ or above. However, there is an exception. You can withdraw money from your IRA to buy your first home or for certain educational expenses.

Alternatives to a 401(k) Hardship Withdrawal

Before tapping into your 401(k) through a hardship withdrawal, it’s worth exploring other options that might offer more flexibility or help you avoid penalties and taxes. Let’s look at a couple of common alternatives that could work in your favor.

1. 401(k) Loan

   Instead of withdrawing funds, you may be able to borrow from your 401(k) account and repay it over time. You can avoid taxes and penalties as long as the loan terms are met.

   You might wonder, “How does a 401(K) loan work“? It is pretty simple! You can borrow up to $50,000 or 50% of your vested balance, repayable over five years.

2. In-Service Withdrawals

   Some 401(k) plans allow you to make penalty-free in-service withdrawals while still employed, usually after reaching age 59½ or for specific emergencies outlined by the plan.

Additional Approaches

• Emergency FundIdeally, 3-6 months of expenses in a high-yield savings account.
• HSA (Health Savings Account)Tax-advantaged medical spending for qualified expenses.
• Regular Brokerage AccountLiquidity without tapping retirement funds.
• Roth IRAWithdraw contributions (not earnings) anytime tax-free.

If you have to use your retirement savings before age 59½, a 401(k) loan might be a sensible option. But if your plan doesn’t allow borrowing, a hardship withdrawal can be a possibility. However, proceed with it only after understanding its underlying implications.

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