Key points
- A hardship withdrawal is limited to the amount necessary to satisfy the financial need.
- This type of withdrawal should be a last resort.
- Better alternatives may include emergency funds, loans and credit cards.
Just about everyone has experienced a surprise expense or financial emergency. Maybe your partner lost their job, or perhaps you received an expected bill for a car repair or medical procedure. Whatever it is, you need to come up with the money to pay for it.
But many people don’t have the savings to pay for surprise expenses. The good news is that if you have a 401(k), you may have an option available to help you weather the financial storm:a 401(k) hardship withdrawal.
A 401(k) hardship withdrawal allows you to access your retirement savings early, sometimes without penalty. But it isn’t always the wisest choice and generally should be a last resort.
What is a 401(k) hardship withdrawal?
A hardship withdrawal is a distribution from a 401(k) because of a financial need. Experiencing financial hardship is one of a handful of situations in which you can withdraw funds from your 401(k). Others include:
- Becoming disabled.
- Experiencing unemployment.
- Reaching age 59½.
- The 401(k) plan is terminating and not being replaced by another defined contribution plan.
“The withdrawal is taken because you are experiencing financial hardship that you can’t cover through other means,” says Joseph Carpenito, a financial advisor with Materetsky Financial Group. “This is generally a last resort option, as it can have significant financial consequences.”
You can take a hardship withdrawal only if you have an “immediate and heavy financial need.” And unlike some alternatives, such as a 401(k) loan, you do not repay the hardship withdrawal to the plan.
Eligibility for a 401(k) hardship withdrawal
Eligibility for a 401(k) hardship withdrawal depends on a couple of factors, including your employer and your financial situation. First, each company can decide whether to allow 401(k) plan participants to receive hardship withdrawals.
“Anyone who is an active participant in a 401(k) plan should be eligible for a hardship withdrawal if the plan allows for these forms of distributions,” says Bob Wootton, a certified financial planner and senior wealth advisor for Capstone Financial Advisors.
Most 401(k) plans have provisions for these hardship withdrawals. But each 401(k) plan may have its own eligibility requirements to be able to take a hardship distribution, so it is always best to reach out to the company or 401(k) plan administrator to determine if you would be eligible.
It’s generally up to the employer to determine whether an employee has an immediate and heavy financial need. Some expenses, such as large consumer purchases, are not considered by the IRS to meet the requirements for a hardship withdrawal.
But there are some situations in which an employee is automatically considered to have an immediate and heavy financial need. These include:
- Medical expenses for the employee or their spouse, dependent or beneficiary.
- Costs related to the purchase of the employee’s principal residence (not including mortgage payments).
- Tuition, room and board, or other educational expenses for the employee or their spouse, child, dependent or beneficiary.
- Payments that are necessary to prevent eviction or foreclosure.
- Funeral expenses for the employee or their spouse, child, dependent or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
How much you can withdraw
With a hardship withdrawal, you can withdraw only enough to cover your immediate and heavy financial needs, according to the IRS. For example, if you have $10,000 worth of medical bills you need a hardship withdrawal to cover, you can withdraw $10,000. But you can’t withdraw extra funds to cover the cost of some purchases you’ve been planning.
Employers can require proof from the employee of the amount of financial hardship. For example, if you are using a hardship withdrawal to pay your medical bills, your employer may require that you provide those medical bills.
To use a hardship withdrawal, you must not have the funds elsewhere to cover the expense. In other words, if you have an emergency fund that would cover your financial hardship, you can’t turn instead to a hardship withdrawal.
Cost of a 401(k) hardship withdrawal
Unless you’re withdrawing money from a Roth 401(k) — meaning one with after-tax contributions — you’ll have to pay income taxes on your withdrawal. This withdrawal will be taxed like your regular income, meaning at your normal effective tax rate ranging from 10% to 37%.
In many cases, a hardship withdrawal will also be subject to the 10% early withdrawal penalty the IRS imposes on distributions before age 59½.
Example: Suppose you withdraw $10,000 for a financial hardship that isn’t exempt from the early withdrawal penalty. Let’s also assume that you have a 15% effective tax rate, meaning your average tax rate. First, you would pay income taxes on your withdrawal in the amount of $1,500, which is 15% of $10,000. You would pay an additional $1,000 for the 10% early withdrawal penalty. So after withdrawing $10,000, you would end up with only $7,500.
“These costs can add up quickly and significantly impact your retirement savings, so it’s important to consider all other options before taking a hardship withdrawal,” Carpenito says.
The good news is that the IRS makes some exceptions to the 10% early withdrawal penalty. They include:
- Total and permanent disability.
- Payments that are made under a qualified domestic relations order.
- A series of substantially equal periodic payments.
- Unreimbursed medical expenses above a percentage of adjusted gross income.
Keep in mind that even if your hardship withdrawal is exempt from the 10% early withdrawal penalty, you will have to pay income taxes on the full amount.
How to make a 401(k) hardship withdrawal
“To request a hardship withdrawal, participants should access specific requirements from their company website or contact a 401(k) customer service representative to determine the steps that are necessary, as each company may have their own process to make this withdrawal request,” Wootton says.
Some companies allow 401(k) plan participants to request hardship withdrawals online. If your plan doesn’t, you can request a hardship withdrawal in writing. Once you’ve made your request, you’ll wait anywhere from one week to one month, depending on the company and its approval process. You may receive the funds via direct deposit or a paper check.
When the payment is processed, your employer will withhold a mandatory 20%, in accordance with federal law. But your actual tax liability could be more or less than that, depending on your annual income and deductions.
Alternatives to a 401(k) hardship withdrawal
A hardship withdrawal is one way to get through a financial emergency. But it should generally be a last resort. There are several other options you may want to consider before turning to a hardship withdrawal.
“It’s important to exhaust all other options before taking a 401(k) hardship withdrawal, as the costs can be significant and impact your retirement savings,” Carpenito says.
Use your emergency fund
The best alternative to a 401(k) hardship withdrawal is to use your emergency fund. In a perfect world, everyone would have emergency savings built up for financial emergencies.
To avoid having to make a hardship withdrawal, if possible, it is always better to have an emergency fund in place of at least three to six months of expenses to be able to manage unexpected expenses.
But that’s often not the case. According to the most recent data from the Federal Reserve, only 59% of U.S. adults have three months of emergency savings.
If a financial emergency arises and you don’t have an emergency fund, there’s little you can do about it. But if your finances are in good shape today, you can start building your emergency savings for the next time a surprise expense arises.
Take a 401(k) loan
Although still not ideal, it is usually preferable to request a 401(k) loan before a hardship withdrawal.
Unlike a 401(k) hardship withdrawal, a 401(k) loan is exempt from taxes and penalties as long as you pay it back on time.
“This enables someone to put these withdrawn loan funds back into the 401(k) plan for future retirement needs,” Wootton says.
But this route still has some disadvantages. First, you’re limited to borrowing 50% of your vested balance or $50,000, whichever is less. And if you don’t repay the loan on time, it will be considered an early withdrawal.
A final downside of a 401(k) loan is what happens if you lose your job. Your loan may be treated as a distribution and subject to taxes and penalties, or you may have to repay the entire loan amount immediately.
Tap into your home equity
There are several ways you can use your home equity to cover an emergency expense. Here are the three primary options:
- Home equity loan. This is an installment loan secured by your home. You’ll borrow a lump sum of money and make fixed payments at a fixed interest rate for the predetermined loan term.
- Home equity line of credit. A HELOC also allows you to borrow against your home equity, but it works more like a credit card than an installment loan. You’ll have a certain credit limit and can borrow up to that limit at any time during the draw period.
- Cash-out refinance: This is a refinance loan, meaning it fully replaces your mortgage. But unlike other refinance loans, you’ll borrow more than your loan balance and get the difference in cash.
All three options have important benefits, including using the money for any purpose. Additionally, interest rates tend to be lower because your home secures the loan.
But they also have a clear downside: You’re using your home as collateral. If you can’t make your payments, you risk losing your home.
Get a personal loan
A personal loan is an installment loan, just like a home equity loan. You borrow a lump sum, usually at a fixed interest rate. Then you repay the loan in fixed amounts over a predetermined term.
The key difference between a personal loan and a home equity loan is that a personal loan is unsecured, meaning there’s no collateral. The good news is that you aren’t risking any assets by borrowing the money. The bad news is, because there’s more risk for the lender, you’ll usually have a higher interest rate.
Get a 0% APR credit card
Many credit cards allow you to pay 0% APR on purchases for a certain period after opening them (often anywhere from six months to two years).
This credit card type has some key benefits. As long as you pay off your balance by the end of the introductory APR period, you won’t pay any interest, which is more than we can say about any other loan options we mentioned.
Be careful, though, because if you don’t pay off your balance before the introductory period ends, you’ll likely be stuck with a high-interest rate.
Frequently asked questions (FAQs)
It used to be the case that employees had to provide their employers with proof of their financial hardships before they could take hardship withdrawals. The IRS no longer requires employers to have that documentation but does advise that employees keep it in case they are audited.
Because each employer and 401(k) administrator operates differently, you may be required to provide documentation to prove that you’re facing hardship. That documentation could include medical bills or other records.
Yes, like other 401(k) distributions, a hardship withdrawal is taxable, assuming it’s a pretax 401(k), not a Roth 401(k). Withdrawals will always be taxed at your ordinary income tax rate. And unless your withdrawal meets one of the exceptions the IRS offers, it will also be subject to the 10% penalty.
The time it takes to make a hardship withdrawal depends on your 401(k) provider and how straightforward your request is. But it generally can take anywhere from one week to several weeks.
