WHAT IS Hardship Withdrawal

Hardship withdrawal is an emergency withdrawal from a retirement plan that may be subject to certain tax or account penalties. In the United States, funds withdrawn prior to the age of 59.5 are typically subject to a 10 percent Internal Revenue Service, or IRS, early withdrawal penalty, as well as standard income taxes.

BREAKING DOWN Hardship Withdrawal

Hardship withdrawals from a retirement plan such as a 401k cannot be replaced. The money that is withdrawn is permanently removed from the account, and only scheduled future contributions are permitted. The stiff penalties and criteria for hardship withdrawals are meant to deter investors from using this option except as a last resort. The ability to have money free from future income taxes and capital gains taxes, a trait of most retirement accounts, is a valuable asset, and is necessary for many to achieve stable retirement.

Systematic withdrawal plan as alternative to hardship withdrawals

Investors may structure and use a systematic withdrawal plan, or SWP, for various payout needs, including retirement. SWPs can be structured as investment vehicles in the market including: mutual funds, annuities, brokerage accounts, 401k plans and individual retirement accounts, or IRAs. Retirement investment account SWPs require additional due diligence because they are regulated by IRS guidelines. The IRS requires that investors begin taking withdrawals from a traditional IRA, SEP IRA, SIMPLE IRA or retirement plan account at the age of 70½.

For standard investment accounts, mutual funds and other account providers will require a SWP form, or distribution form. Investors can determine various distribution schedules including monthly, quarterly, semi-annually or annually. Accounts typically have a minimum balance requirement for beginning systematic withdrawals. For convenience, investors may have the option to specify liquidation percentages by funds for accounts with multiple holdings. This can occur with mutual fund company holdings, brokerage accounts or portfolios managed by a financial advisor. In preparing for and initiating a SWP, investors need to consider taxes and potentially a systematic transfer plan. A tax advisor can help determine the tax rate for withdrawals from standard and retirement accounts.

Because withdrawals require selling securities to make distributions from standard accounts, typically they are taxed as income, and retirement account withdrawals have their own tax structure. Systematic withdrawal plan calculators or standard retirement calculators are useful in planning. They help investors determine the target amount needed to cover withdrawals. Variables include age, annual salary, retirement savings income allocation, current allocation, retirement income needs, expected annual return from investment, social security estimates and other retirement fund estimates.