What Is a Hardship Withdrawal?
A hardship withdrawal is an emergency removal of funds from a retirement plan, sought in response to what the IRS terms "an immediate and heavy financial need." Such special distributions may be allowed without penalty from such plans as a traditional IRA or a 401k, provided the withdrawal meets certain criteria for why the funds are needed, and their amount. However, even if penalties are waived (notably the 10% penalty for withdrawals made before age 59½), the withdrawal will still be subject to standard income tax.
- If you're younger than 59½ and suffering financial hardship, you may be able to withdraw funds from your retirement accounts without incurring the usual 10% penalty.
- Not all hardships qualify, however, and you're still responsible for paying income tax on the withdrawals.
- Keep in mind that you won't be able to return the funds to the account if and when your finances improve.
- Consider other alternatives to hardship withdrawals, including a Substantially Equal Periodic Payments (SEPP) plan.
Understanding Hardship Withdrawals
Hardship withdrawals can provide needed funds in an emergency—without a credit check—but they should be used very sparingly and only if all other alternatives have been tried or dismissed. By exposing funds held in a tax-sheltered fund to income tax, a hardship withdrawal is likely to boost your tax bill for the year. Even more important, it will permanently deprive you of funds targeted for your retirement. Unlike, say, a loan you take from your 401(k), the funds from a hardship withdrawal cannot be returned to the account if and when your financial position improves.
Because of these disadvantages, consider a hardship withdrawal only as a last resort to meet an exceptional and pressing need. Indeed, the IRS and most employers who offer 401(k)s impose stringent criteria for these distributions to limit when they may be used and their amount.
The rules that govern such withdrawals, and who administers them, differs by the type of retirement fund.
Hardship withdrawals from IRAs
The IRS will waive the 10% penalty for IRA withdrawals made before age 59½ that are prompted by medically related hardship. If you do not have health insurance or your medical expenses are more than your insurance will cover for the year, you may be able to take penalty-free distributions from your IRA to cover these expenses. Or some of them, at least. Only the cost difference between these expenses and 7.5% of your adjusted gross income (AGI) is eligible.
If you are unemployed, you're permitted to make penalty-free distributions to pay for your medical insurance. However, to qualify, you must have have lost your job, rather than simply left it voluntarily, and must have received federal or state unemployment compensation for 12 consecutive weeks. Concerning timing, you must receive the distributions the year, or the year after, you received the unemployment compensation and no later than 60 days after you get another job. And the bills must be large—representing at least 10% of your AGI—and must not be covered by any health insurance.
The IRS also allows early, penalty-free withdrawals from IRAs for other reasons that may or may not be prompted by hardship. These include having a mental or physical disability, or needing funds to pay higher-education bills for you, your spouse, or your children or grandchildren.
Hardship Withdrawals from 401(k)s
Whether or not you may take a hardship distribution from your 401(k) or similar 403(b) plans—and for which reasons—is up to the employer who sponsors the program. “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.
If your employer permits a withdrawal for a particular reason, though, IRS rules govern whether or not the 10% penalty for withdrawals made before age 59½ will be waived, as well as how much you're allowed to withdraw. These conditions are similar to those governing waivers for IRA withdrawals, but there are some differences. Notably, you can't withdraw from your 401(k) without penalty to pay your medical insurance premiums, as you can with an IRA. Nor are withdrawals to pay educational expenses or to buy a first home free from penalties; both are permitted penalty-free for IRA withdrawals, under certain conditions.
Orderly Payments as an Alternative to Hardship Withdrawals
There's another option to tap your retirement accounts before age 59½ without incurring penalties, but it requires more time to set up and a longer-term commitment to early withdrawals. The funds you wish to tap can be placed into Substantially Equal Periodic Payments (SEPP) plan. The plan will then pay you, without penalty, annual distributions for five years or until you turn 59½, whichever comes later. As with hardship withdrawals, only the penalties are waived; you're still liable for paying income tax on the early withdrawals.
Because the IRS requires individuals to continue the SEPP plan for at least five years, this is not a solution for those who seek only short-term access to retirement funds without penalty. If you cancel the plan before the minimum holding period expires, you're required to pay the IRS all the penalties that you were waived under the program, plus interest on that amount.
Also, funds held in an employer-sponsored qualified plan, such as as a 401(k), can be used in a SEPP only if you no longer work for the sponsoring employer. Once you start a SEPP program on a retirement account, too, you may not make any additions to or distributions from the account. Any changes to the account balance, with the exception of the SEPPs and required fees, such as trade and administrative charges, may result in a modification of the SEPP program and could be cause for disqualification by the IRS—and, again, imposition of all penalties that were waived, plus interest.
Despite these limitations and drawbacks, a SEPP plan is worth considering in cases where you need to tap funds early. Among other pluses, the programs are less restrictive regarding how you spend the funds you withdraw without penalty than are hardship withdrawals.