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 You've been faithfully building your 401k plan at work, but you suddenly find yourself with a financial hardship. This leaves you wondering - Is it possible to make a 401k hardship withdrawal? The answer to this question is not quite that simple.
401k Retirement Plans
The purpose of 401k plans is to encourage individuals to save for retirement. Tax law allows you to fund your plan with pre-tax dollars and allows that money to grow on a tax-deferred basis until withdrawal. In exchange for the tax shelter that a 401k plan provides to employees, tax law restricts the withdrawal of that money before age 59 1/2.
401k Withdrawals
Some 401k plans will allow employees to withdraw funds for any reason. Typically, these 401k withdrawals are limited to the elective portion of the deferral, and not any income or interest on the deferred amounts. However, these types of plans are more the exception than the rule. Generally, money can be withdrawn from a 401k account if a financial hardship exists, and only in very limited situations.
Financial Hardship Definition
The exact rules followed by each 401k plan will vary, but generally a financial hardship is deemed to exist if a participant in the plan experiences an immediate and heavy financial burden. In addition, the participant must have no other financial means of meeting this hardship. Examples of financial hardship include:
- Potential eviction / foreclosure on the participant's principle residence.
- The participant needs substantially all of his or her current and anticipated income and assets to meet their current and anticipated ordinary and necessary living expenses.
True financial hardship usually does not exist when the participant only attempts to establish that the repayment of money causes a financial burden. That is, the burden of proof must be greater than merely the inconvenience of repaying a debt.
To discourage the use of 401k plan funds for any reason other than retirement purposes, early withdrawals are subject to a 10% penalty. This means any money withdrawn from the 401k account before age 59 1/2 are not only subject to income taxes based on your incremental tax bracket, but also a 10% penalty. The tax code does, however, allow penalty-free withdrawals if the hardship meets certain criteria.
Criteria for 401k Hardship Withdrawals
There are basically three ways money can be taken from a 401k account without penalty:
- The distribution or withdrawal must be made after termination of employment, if you are age 55 or older in that calendar year.
- Distributions or withdrawals are made to an alternate payee under a qualified domestic relations order. This typically happens as part of a divorce settlement.
- Withdrawals or distributions of dividends from employee stock ownership plans or ESOP.
Safe Harbor Hardship Withdrawals
The IRS also has a provision for employers to provide for a safe harbor withdrawal from a 401k plan if there exits an immediate and heavy financial need or burden. The only money exempt under the safe harbor rule is that which is used to satisfy that immediate and heavy financial need. According to the IRS the safe harbor hardship withdrawals from a 401k plan are limited to:
- Money used to pay certain medical expenses for you, your spouse, or any of your dependents.
- Payments of specific post-secondary education expense for the next year for you, your spouse, or any of your dependents.
- The purchase of a primary residence.
- Money needed to prevent eviction or foreclosure on your primary residence.
Hardship withdrawals made under the safe harbor provision may exclude you from making contributions to your 401k plan for six months or more. Federal income tax on the hardship withdrawal may be deferred until age 59 1/2, but a 10% penalty may still apply.
Prior to any kind of hardship withdrawal, a 401k plan participant usually is required to take all other possible forms of non-hardship distributions from their account. This can include loans as well as the withdrawal of after tax savings / money in their account. As with any decision that can impact your financial future, you should consult with your 401k plan administrator and / or a tax advisor.
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