Hardship Withdrawal vs. 401(k) Loan: An Overview
Is it ever OK to borrow from your 401(k) plan, either as a 401(k) loan or a hardship withdrawal? After all, your plan is a powerful retirement savings tool and should be carefully handled. Indeed, data from Fidelity shows that the average account balance has climbed to $112,300, as of February 2020.
The recently enacted CARES Act lets you make a penalty-free COVID-19 related withdrawal or take out a loan from your 401(k) in 2020 with special repayment provisions and tax treatment.
The primary advantage of saving in a 401(k) is the ability to enjoy tax-deferred growth on your investments. When you’re setting aside cash for the long term, a hands-off approach is usually best. Nevertheless, there are some scenarios in which taking money out of your 401(k) can make sense.
Before you pull the trigger, though, it’s important to understand the financial implications of tapping your retirement plan early. There are two basic avenues for taking some money out before reaching retirement age.
- Hardship withdrawals are only allowed when there’s an immediate and heavy financial need, and typically withdrawals are limited to the amount required to fill that need.
- For calendar year 2020, COVID-19 related hardship withdrawals can be up to 100% of your account balance or $100,000, whichever is smaller.
- Under regular IRS guidelines you can borrow 50% of your vested account balance or $50,000, whichever is less, as a 401(k) loan.
- If the loan was COVID-19 related (CRD) and taken out between March 27 and December 31, 2020, up to 100% or $100,000, whichever is less, receives special IRS treatment.
- If you’re not in dire financial straits but still want to take cash from your 401(k) plan, a loan is usually best.
One way is to take a hardship withdrawal. The Internal Revenue Service (IRS) specifies that hardship withdrawals are allowed only when there’s an immediate and heavy financial need, and withdrawals are normally limited to the amount required to fill that need. These withdrawals are subject to ordinary income tax and, if you’re under the age of 59½, there is a 10% early withdrawal penalty (except if you're affected by the COVID-19 pandemic; see below.)
The IRS offers a safe harbor exception allowing someone to automatically meet the heavy-need standard if they are in certain situations. For example, a safe harbor exception is allowed for people who need to take a hardship withdrawal to cover medical expenses for themselves, a spouse, or dependents. If you find yourself in a life-or-death medical situation—say, one requiring emergency surgery—taking a hardship withdrawal could help to cover the gap if your insurance coverage falls short.
A hardship withdrawal could also be useful if you experience an extended period of unemployment and don’t have an emergency fund to fall back on. The IRS waives the penalty if you’re unemployed and need to purchase health insurance, although you’d still owe taxes on what you withdraw. Other situations that are covered by the safe harbor exception include:
- Tuition, related educational fees, and room-and-board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.
- Payments are necessary to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
Special COVID-19 Hardship Withdrawal for 2020
If you qualify for a Coronavirus-Related Distribution (CRD) from your 401(k) plan during calendar year 2020, that distribution will be treated as a safe-harbor distribution not subject to a 10% early withdrawal penalty if you are under 59½ but subject to regular income taxes.
Additional unique stipulations to this special distribution provide that:
- You can withdraw up to 100% or $100,000 of your account balance, whichever is smaller.
- You can spread out any taxes due over three years.
- If you pay the funds back into your account within three years, it will be considered a rollover and not subject to taxes.
New guidance from the IRS June 19, 2020, expands guidelines for eligibility for a hardship withdrawal to include having a job start date delayed or a job offer rescinded due to COVID-19. The guidelines also allow a spouse of an affected worker to make a hardship withdrawal, even if the spouse is still working.
If you’re not in dire financial straits but still want to take cash from your plan, a 401(k) loan is the other option. Under IRS guidelines, you can borrow 50% of your vested account balance or $50,000, whichever is less. A loan, however, has both pros and cons.
For example, a loan is just that—a loan, not a distribution. You’re essentially paying back the money to yourself, which means you’re putting it back into your retirement account, and that’s a positive. Loans are usually repaid with interest, which can make up somewhat for the earnings you’re losing by not leaving the money in your plan.
The downside is that if you leave your job and don't repay the loan within a specified period (just extended to the due date of your federal income tax return, instead of the previous 60-to-90 day window, under the Tax Cuts and Jobs Act), it’s treated as a regular distribution. In that case, the income tax and early withdrawal penalty would apply.
Special COVID-19 401(k) Loans for 2020
Similar to the special provisions for hardship withdrawals that qualify as a CRD, loans taken from a 401(k) between March 27, 2020 and December 31, 2020 are also subject to special IRS provisions. Loans of up to $100,000 or 100% of the amount in your employer-sponsored retirement plan (whichever is smaller) taken anytime between Mar. 27, 2020, and December 31, 2020, are eligible for a one year suspension of payments, though interest will accrue. If you already have an an outstanding loan those payments can also be deferred for one year.
So when is it wise to use a loan? There are situations in which you might consider it.
You could use a 401(k) loan to consolidate high-interest debt if your credit doesn’t qualify you for a low rate on a personal loan or debt consolidation loan. Comparing how much you’re paying in interest on your credit cards or other debt to the interest rate your 401(k) plan administrator charges can help you decide which is the better deal.
Buying a home
Your 401(k) could also be a source of cash when you’re planning to buy a home. You could use the money to cover closing costs or hold it in your down-payment savings account for a few months before buying, so the funds are seasoned.
Generally, a 401(k) loan must be repaid within five years, making at least quarterly payments, but the IRS allows provisions for plan administrators to extend the repayment period longer for homebuyers.
Making an investment
Using a 401(k) loan to make an investment may sound like a gamble, but it could be appropriate if certain conditions exist. Let’s say, for example, that you want to purchase a home as an investment property. You plan to renovate the home and flip it for a profit but need capital to make the purchase. If you’re confident that the project will yield a big enough return, you could use money from your 401(k) to buy it or pay for renovations, then use the proceeds from the sale to pay back what you borrowed.
When you have a comfortable retirement cushion
If you’ve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If that’s the case, and your job is stable, taking a loan from your 401(k) may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for example—or, if you have a child in college, as a less expensive alternative to student loans.
Ideally, your 401(k) plan should have a steady stream of money going in, rather than out. If you do decide to take a loan from your plan—or a financial need makes a hardship withdrawal a necessity—be sure you understand the potential tax consequences of doing so. If you are unsure of the consequences you may want to consider seeking the advice of a qualified financial planner prior to making a decision to take a hardship withdrawal or a loan from your 401(k).
Also, consider how taking that money out may affect the growth of your nest egg over the long term. Taking out a large withdrawal or loan may mean you’ll have to play catch up to reach your retirement savings goal.