401k Hardship Withdrawal

You've been faithfully building your 401k plan at work, but you suddenly find yourself facing a financial hardship. This leaves you wondering: Is it possible to make a 401k hardship withdrawal? Unfortunately, the answer to this question is not that simple.

401k Retirement Plans

The purpose of 401k plans is to encourage individuals to save for retirement. Tax laws allow you to fund your plan with pre-tax dollars, and allow 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 laws restrict the withdrawal of that money before age 59 1/2.

401k Withdrawals

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Some 401k plans 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 Generally, money can be withdrawn from a 401k account if a financial hardship exists, and only in very limited situations.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 hardships include:

Potential eviction or foreclosure on the participant's principal 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.

Demonstrating true financial hardship usually requires more proof than just the repayment of money owed lenders. 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 This means any money withdrawn from the 401k account before age 59 1/2 many not only be subject to income taxes based on your incremental tax bracket, but also a 10% penalty. The tax code, however, does 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 often 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 an immediate and heavy financial need or burden exists. 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 or distributions are includible in gross income for federal income tax purposes, unless they consist of Roth contributions. They may be also be subject to a 10% additional tax on early distributions of elective contributions.

Prior to any kind of hardship withdrawal, a 401k plan participant is usually 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 money in their account. As with any decision that can affect your financial future, you should consult with your 401k plan administrator and / or a tax advisor.

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