When a 401(k) Hardship Withdrawal Makes Sense

Many workers count on their employer-sponsored 401(k) for the lion’s share of their retirement funds. That’s why these accounts shouldn’t be the first place you go if you need to make a major expenditure or are having trouble keeping up with your bills.

But if better options are exhausted – for example, an emergency fund or outside investments – tapping your 401(k) early may be worth considering. Most major employers allow hardship withdrawals if employees meet specific guidelines. And in some cases, you can pull money out without paying a 10% percent penalty to the IRS, which is normally the case when you withdraw retirement funds before age 59½.

If your employer offers 401(k) loans – which differ from hardship withdrawals – borrowing from your own assets may be a better way go. Under IRS guidelines, savers can take out up to 50% of their vested balance, up to $50,000. One of the advantages of a loan is that the plan participant isn’t forced to pay income taxes on it that same year. Be aware, however, that you have to repay the loan within five years (ensuring that your retirement fund doesn’t get depleted), which requires steady employment. “An outstanding loan with a job termination triggers immediate 60-day repayment, tax liability and potential penalties if you’re under 59½,” says Jason R. Tate of Jason Tate Financial Consulting in Murfreesboro, Tenn.

But in certain circumstances (for example, if your company doesn’t offer loans), a hardship withdrawal may make sense. In some cases, you will owe taxes; in others you won’t. Here are some rules you need to know.

Plan participants can draw on their 401(k) balance to pay for medical expenses that insurance doesn’t cover. If the bills exceed 10% of the individual’s adjusted gross income (AGI), the 10% tax penalty is waived. To avoid the fee, the hardship withdrawal must take place in the same year that the patient received medical treatment.

As with most hardship withdrawals, the amount you can take out is generally equal to the amount of your elective contributions, less any previous distributions.

If you become “totally and permanently” disabled, getting access to your retirement account early becomes easier. The government allows you to withdraw funds before age 59½ without penalty. Be prepared to prove that you’re truly unable to work. Disability payments from either Social Security or an insurance carrier usually suffice, though a doctor’s confirmation of your disability is frequently required.

Keep in mind that if you are permanently disabled, you may need your 401(k) even more than most investors. Therefore, tapping your account should be a last resort, even if you lose the ability to work.

If you’ve left your employer, the IRS allows you to receive “substantially equal periodic payments” penalty-free (though they’re technically not hardship distributions). One important caveat is that you make these regular withdrawals for at least five years or until you reach 59½, whichever is longer. That means that if you started receiving payments at age 58, you’d have to continue doing so until you hit 63. As such, this isn’t an ideal strategy for meeting a short-term financial need. If you cancel the payments before five years, all penalties that were previously waived will then be due to the IRS.

There are three different methods you can choose for calculating the amount of your withdrawals: fixed amortization, fixed annuitization and required minimum distribution. A trusted financial advisor can help you determine which method is most appropriate for your needs. Regardless of which method you use, you’re responsible for paying taxes on any income, whether interest or capital gains, in the year of the withdrawal.

Those who retired or lost their job in the year they turned 55 or later have yet another way to pull money from their employer-sponsored plan. Under a provision known as “separation of service,” you can take an early distribution without worrying about a penalty. But as with other withdrawals, you’ll have to be sure you can pay the income taxes. Of course, if you have a Roth version of the 401(k), you won’t owe taxes because you contributed to the plan with post-tax dollars.

Under U.S. tax law, there are several other scenarios where an employer has a right, but not an obligation, to allow hardship withdrawals. These include the purchase of a principal residence, payment of tuition and other educational expenses, prevention of an eviction or foreclosure and funeral costs.

However, in each of these situations, even if the employer does allow the withdrawal, the 401(k) participant who hasn’t reached age 59½ will be stuck with a sizable 10% penalty on top of paying ordinary taxes on any income. Generally, you’ll want to exhaust all other options before taking that kind of hit. “In the case of education, student loans can be a better option, especially if they’re subsidized,” says Dominique Henderson, Sr., owner of DJH Capital Management, LLC, a registered investment advisory firm in Cedar Hill, Texas.

If employees absolutely need to use their retirement savings before age 59½, 401(k) loans are ordinarily the first method to pursue. But if borrowing isn’t an option, a hardship withdrawal may be a possibility for those who understand the implications. Take note of which situations would institute a 10% penalty and which won’t. This may make the difference between a smart method of getting cash or a costly blow to your future retirement.