If you need a significant sum of money and don't expect to have the means to repay it, one option that may be available is a hardship withdrawal from your 401(k) at your current employer. This is not the same as a 401(k) loan and comes with a long list of detailed rules.

The 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. They go into effect in 2019. Here's what you need to know about your expanded options.

One caveat before we get started: Employers don't have to offer hardship withdrawals, or the two other ways to get money from your 401(k)—loans and non-hardship in-service withdrawals. But if yours does, and you’re considering tapping your retirement account early, you should know the territory. 

For starters, let's look at what you need to prove in order to qualify for a hardship withdrawal.

Key Takeaways

  • A hardship withdrawal from a 401(k) retirement account can help you come up with much-needed funds in a pinch.
  • Unlike a 401(k) loan, the funds to do not need to be repaid.
  • A hardship withdrawal can give you retirement funds penalty-free, but only for certain specific qualified expenses such as medical bills or tuition.

What Is a Hardship Withdrawal?

The Internal Revenue Service (IRS) defines a hardship as an “immediate and heavy financial need” of the employee, the employee’s spouse, the employee’s dependent, or the employee’s non-spouse, non-dependent beneficiary. Immediate and heavy expenses include the following: 

  • certain medical expenses
  • home-buying expenses for a principal residence
  • up to 12 months’ worth of tuition and fees
  • expenses to prevent being foreclosed on or evicted
  • burial or funeral expenses
  • certain expenses for a principal residence to repair casualty losses to a damaged home (such as losses from fires, earthquakes, or floods)

You can’t just withdraw as much as you want; it must be the amount “necessary to satisfy the financial need.” That sum includes what’s needed to pay taxes and penalties on the withdrawal. You won’t qualify for a hardship withdrawal if you have other assets that you could draw on to meet the need or insurance that will cover the need.

Hardship Withdrawals Get Easier, Larger

It will soon become easier to take a larger hardship withdrawal from your 401(k) or 403(b) plan, thanks to provisions in the Bipartisan Budget Act. Under the old rules, 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. Also, taking a hardship withdrawal meant you couldn't make new contributions to your plan for the next six months. 

Excerpt from U.S. legislation describing a hardship withdrawal

Source: Congress.gov.

Under the new rules, you may, if your employer allows it, be able to withdraw your employer’s contributions plus any investment earnings in addition to your salary-deferral contributions. You’ll also be able to keep contributing, which means you’ll lose less ground on saving for retirement and still be eligible to receive your employer’s matching contributions. An additional change is that you won’t be required to take a plan loan before you become eligible for a hardship distribution.

Additional excerpt from legislation defining a hardship withdrawal with regards to cash or deferred arrangements

Source: Congress.gov.

These changes to the hardship withdrawal rules don’t apply to whether you can take a hardship distribution in the first place. That decision is still up to your employer. “A retirement plan may, but is not required to, provide for hardship distributions,” the IRS states. If the plan does allow such distributions, it must specify the criteria that define a hardship, such as paying for medical or funeral expenses. Your employer will ask for certain information and possibly documentation of your hardship.

Some might argue that the ability to withdraw not just salary-deferral contributions but also employer contributions and investment returns is not an improvement to the program. Here’s why.

Hardship Withdrawals Will Cost You

Hardship withdrawals hurt you in the long run when it comes to saving for retirement. The more money you withdraw, the greater the pain. Unlike loans, withdrawals can’t be repaid, and you may pay a 10% early withdrawal penalty if you are younger than 59.5, plus income taxes, on the amount you take out.

10%

The penalty on withdrawn retirement funds before age 59.5, in addition to paying taxes due, if they do not meet the criteria for a hardship.

Whether you’ll pay the penalty depends on your reason for taking the withdrawal. The only early 401(k) withdrawals that aren’t subject to the 10% penalty are those taken under the following circumstances:

  • corrective distributions (money repaid to highly compensated employees deemed to have contributed too much to a 401(k) compared to other employees—income tax is owed on this money)
  • death
  • total and permanent disability
  • qualified domestic relations orders (issued as part of a divorce decree)
  • IRS levies on the plan
  • a series of substantially equal periodic payments
  • dividend pass-through from an Employee Stock Ownership Plan
  • medical expenses in excess of 10% of adjusted gross income (AGI)
  • employee separation from service after age 55
  • certain distributions to qualified military reservists called to active duty   

Also, note that 401(k) no-penalty withdrawal rules are slightly different from those for withdrawing from a traditional IRA.

Other Options for Getting 401(k) Money

If your employer permits it, you may also have access to non-hardship in-service withdrawals or a 401(k) loan. Non-hardship withdrawals may have certain restrictions about your age or which funds you can withdraw. Loans are generally permitted for the lesser of half your 401(k) balance or $50,000 and must be repaid with interest. All of these choices can have tax implications, which you should explore with a financial advisor.

401(k) loans must be repaid with interest in order to avoid penalties.

The Bottom Line

While the government has made it easier, starting in 2019, to take a larger hardship withdrawal and get back on track with retirement contributions sooner, you should still consider this option a last resort. You cannot repay a hardship withdrawal. This means you will permanently lose the opportunity to contribute that money to your retirement account and earn years of compound investment returns on it. All the same, hardship loans are a viable and soon-to-be improved option if your employer allows them.