When a 401(k) Hardship Withdrawal Makes Sense

November 9, 2018 — 6:00 AM EST

Many workers count on their 401(k)s for the lion’s share of their retirement savings. That's why these employer-sponsored plans shouldn't be the first place you go if you need to make a major expenditure or are having trouble keeping up with your bills.

But if better options are exhausted – for example, an emergency fund or outside investments – tapping your 401(k) early may be worth considering. Most (though not all) major employers allow hardship withdrawals if employees meet specific guidelines. These aren't the same thing as 401(k) loans, mind you. There are a number of differences: Most notable is that they don't allow money to paid back into the saver's account, thereby missing out on appreciation. There are also potential penalties to be aware of. In some cases, you will owe taxes; in others, you won't. And sometimes, you can pull money out without paying a 10% penalty according to IRS hardship distribution rules, which is normally the case when you withdraw retirement-plan funds before age 59½. The table below summarizes when you owe a penalty and when you don't.

TYPE OF WITHDRAWAL

10% PENALTY?

Medical expenses

No (if expenses exceed

7.5% of AGI)

Permanent disability

No

Substantial equal periodic payments (SEPP)

No

Separation of service

No

Purchase of primary residence

Yes

Tuition and educational expenses

Yes

Prevention of eviction or foreclosure

Yes

Burial or funeral expenses

Yes

 

As for accessibility, there is some good news: The Bipartisan Budget Act passed in January 2018 issued new rules that will make it easier to withdraw a larger amount as a hardship withdrawal from a 401(k) or 403(b) plan. For one, the old rule – which stipulated that that you could only withdraw your own salary-deferral contributions (the amounts you had withheld from your paycheck) from your plan when taking a hardship withdrawal – will be retired in 2019. In addition, the rule that stated that you couldn't make new contributions to your plan for the next six months will also expire in 2019. This will help individuals keep up with retirement saving.

With the new rule you will be able to continue contributing to the plan and also be able to receive employer matching contributions. An additional change for 2019 is that you won’t be required to take a plan loan before you become eligible for a hardship distribution. Whether or not you will be allowed to take a hardship distribution is a decision that still remains with your employer, however. Your employer may also limit the uses of such distributions, such as for medical or funeral costs, as well as require documentation. Here are some additional things to know about hardship withdrawals.

The six tests for a hardship withdrawal did not change with the new law. Hardship withdrawals are permissible due to a heavy financial need due to medical care/costs, the purchase of a principal residence, post-secondary education, to prevent the foreclosure of a principal residence or eviction, funeral or burial expense, and repairs to a principal residence due to a casualty loss that would have been tax-deductible under Section 165 of the Internal Revenue Code (from 2018 to 2025, the Tax Cuts and Jobs Act declared such losses are not tax-deductible except in specified federal disaster areas). 

It should be noted that the Tax Cuts and Jobs Act also reduced the amount individuals can deduct for medical expenses to 7.5% of adjusted gross income for 2017 and 2018. That figure goes back to 10% in 2019.

Hardship Withdrawals and Your Employer

The conditions under which hardship withdrawals can be made from a 401(k) plan are determined by the provisions in the plan document (as elected by the employer). Some plans will allow hardship withdrawals of all plan assets, while others will limit hardship withdrawals to assets attributed to salary deferral contributions.

Paying Medical Bills

Plan participants can draw on their 401(k) balance to pay for medical expenses that health insurance doesn’t cover. If the unreimbursed bills exceed 7.5% of the individual’s adjusted gross income (AGI), the 10% tax penalty is waived. To avoid the fee, the hardship withdrawal must take place in the same year that the patient received medical treatment. 

Again, in 2019 the amount you can take out will no longer be limited to a sum equal to the amount of your elective contributions, minus any previous distributions.

Living with a Disability

If you become “totally and permanently” disabled, getting access to your retirement account early becomes easier. The government allows you to withdraw funds before age 59½ without penalty. Be prepared to prove that you’re truly unable to work. Disability payments from either Social Security or an insurance carrier usually suffice, though a doctor's confirmation of your disability is frequently required. 

Keep in mind that if you are permanently disabled, you may need your 401(k) even more than most investors. Therefore, tapping your account should be a last resort, even if you lose the ability to work.

Substantially Equal Periodic Payments (SEPP)

If you’ve left your employer, the IRS allows you to receive “substantially equal periodic payments” penalty-free (though they're technically not hardship distributions). One important caveat is that you make these regular withdrawals for at least five years or until you reach 59½, whichever is longer. That means that if you started receiving payments at age 58, you’d have to continue doing so until you hit 63.

As such, this isn’t an ideal strategy for meeting a short-term financial need. If you cancel the payments before five years, all penalties that were previously waived will then be due to the IRS.

There are three different methods you can choose for calculating the amount of your withdrawals: fixed amortization, fixed annuitization and required minimum distribution. A trusted financial advisor can help you determine which method is most appropriate for your needs. Regardless of which method you use, you’re responsible for paying taxes on any income, whether interest or capital gains, in the year of the withdrawal. 

Separation of Service

Those who retired or lost their job in the year they turned 55 or later have yet another way to pull money from their employer-sponsored plan. Under a provision known as “separation of service,” you can take an early distribution without worrying about a penalty. But as with other withdrawals, you’ll have to be sure you can pay the income taxes. Of course, if you have a Roth version of the 401(k), you won't owe taxes because you contributed to the plan with post-tax dollars.

What Costs the Most: Withdrawals for Homes and Tuition

Under U.S. tax law, there are several other scenarios where an employer has a right, but not an obligation, to allow hardship withdrawals. These include the purchase of a principal residence, payment of tuition and other educational expenses, prevention of an eviction or foreclosure and funeral costs.

However, in each of these situations, even if the employer does allow the withdrawal, the 401(k) participant who hasn't reached age 59½ will be stuck with a sizable 10% penalty on top of paying ordinary taxes on any income. Generally, you’ll want to exhaust all other options before taking that kind of hit.

"In the case of education, student loans can be a better option, especially if they're subsidized," says Dominique Henderson, Sr., owner of DJH Capital Management, LLC, a registered investment advisory firm in Cedar Hill, Texas.

Another Option: A Loan

If your employer offers 401(k) loans – which differ from hardship withdrawals – borrowing from your own assets may be a better way go. Under IRS 401(k) loan guidelines, savers can take out up to 50% of their vested balance, or up to $50,000 (whichever is less). One of the advantages of a loan is that the plan participant isn’t forced to pay income taxes on it that same year. Nor does it incur that early withdrawal penalty.

Be aware, however, that you have to repay the loan, along with interest, within five years (ensuring that your retirement fund doesn't get depleted). If you and your employer part ways, you have you have until October of the following year – the ultimate deadline (with extension) for filing tax returns – to repay. 

The Bottom Line

If employees absolutely need to use their retirement savings before age 59½, 401(k) loans are ordinarily the first method to pursue. But if borrowing isn’t an option – not every plan allows it – a hardship withdrawal may be a possibility for those who understand the implications. One big downside is that you can't pay the withdrawn money back into your plan, which can permanently hurt your retirement savings. As such, a hardship withdrawal should only be done as a last resort.

You may want to ask the plan administrator or the employer for a copy of the summary plan description agreement (SPD); the SPD will include information about when and under what circumstances withdrawals can be made from your 401(k) account. You can also ask to be provided with an explanation in writing.

Take note of which situations would institute a 10% penalty and which won't. This may make the difference between a smart method of getting cash or a smashing blow to your retirement nest egg.