In case of a financial emergency, it may cross your mind to dip into your 401(k) retirement plan for funds. While the typical rules say you can’t withdraw from your 401(k) until you’re 59 ½ years old or no longer employed, there are certain “immediate and heavy” financial situations where the IRS permits hardship withdrawals.
Extracting funds from a 401(k) is generally a last resort, given the income taxes and 10% penalty can be quite steep. Nevertheless, it is important to be informed about 401(k) hardship withdrawals and how they stack up against other available options.
WHAT IS A 401(K) HARDSHIP WITHDRAWAL?
A 401(k) hardship withdrawal, or hardship distribution, refers to an early withdrawal from your 401(k) – that is, a withdrawal before you reach 59 ½ years old. There are special scenarios in which hardship withdrawals are permitted, like paying for medical care, settling funeral expenses for a spouse or child, or buying a home.
This type of withdrawal could prove helpful in a pinch, but remember, income taxes are due on any withdrawals, and if the funds are taken out before the age of 59 ½, the IRS may levy a 10% early distribution penalty on the amount withdrawn.
WHO IS ELIGIBLE FOR A HARDSHIP WITHDRAWAL?
To qualify for a hardship withdrawal, you must have an urgent and significant financial need that can’t be met by any other readily available assets like liquid investments, savings, or other distributions from your 401(k) plan.
REASONS FOR A 401(K) HARDSHIP WITHDRAWAL
The IRS has identified seven situations that might qualify for 401(k) hardship withdrawals. These include: non-mortgage payment costs for a new home for personal use, certain repair-related expenses for personal residence, payments to avoid eviction from or foreclosure on personal residence, medical expenses, college tuition for the coming 12 months, and funeral expenses, among others.
HARDSHIP WITHDRAWAL LIMITS
The maximum you can draw from your account should cover the urgent financial need plus any taxes and penalties. You can request a minimum of $1,000. If your vested account balance is under $1,000, you won’t be able to get a hardship distribution.
ALTERNATIVES TO A 401(K) HARDSHIP WITHDRAWAL
While a 401(k) hardship withdrawal can be helpful in a crisis, it should be the last option. When you take out money from your 401(k), you lose long-term financial benefits to address a short-term financial need. Before considering a hardship withdrawal, try these alternatives:
401(K) LOAN
This lets you borrow $50,000 or half of the vested amount from your retirement plan, whichever is lesser. You repay the loan with interest, usually over five years. The loan won’t impact your credit rating and won’t be taxable unless you leave your job.
ROTH IRA WITHDRAWAL
With Roth IRAs, you can face an emergency without a tax or penalty, making it a great resource for urgent expenses.
LIFE INSURANCE LOAN
Loans against life insurance policies are available for permanent policies that have a cash value feature. These aren’t without risk, though; unpaid loans can reduce your death benefit or even cost your policy.
PERSONAL LOAN
A personal loan can be a favorable alternative to a retirement account withdrawal, particularly if you have a good credit score.
LOW-INTEREST CREDIT CARD
Credit cards with a 0% APR offer can be a useful solution if you have a good credit score. These cards won’t charge an APR during the introductory period, and you can repay the emergency expense without incurring interest.
CONCLUSION
Experiencing an emergency often leaves limited options. Nonetheless, 401(k) hardship withdrawals should only be a final resort given the taxes, penalties, and potential impact on your retirement savings. Always consider all the borrowing options mentioned above before deciding to withdraw from your 401(k) retirement fund.
