If you experience financial difficulties, it may be tempting to tap into the savings you have accumulated in a 401(k) or similar retirement plan. Many plans permit hardship withdrawals, and the Bipartisan Budget Act of 2018 relaxed some of the rules surrounding these withdrawals. But, even if it is easier for you to access your retirement savings in a pinch, doing so comes at a steep price.
How do you qualify?
Retirement plans may, but are not required to, provide for hardship withdrawals. Typically, these withdrawals are allowed for:
- Unexpected medical expenses;
- Tuition and related fees and expenses;
- Costs related to purchasing a principal residence;
- Payments necessary to avoid eviction from, or foreclosure on, a principal residence;
- Certain expenses for repairing damage to a principal residence; and
- Burial or funeral expenses.
The Budget Act has eased certain requirements for plan participants seeking hardship withdrawals. Notably, it has eliminated the requirement that participants take all available plan loans before receiving a hardship distribution.
In addition, the Budget Act has eliminated the six-month period that previously prohibited participants from making new contributions following a hardship withdrawal. And, it has expanded the types of funds available for hardship withdrawals. Now, participants can withdraw not only elective deferral contributions, but also qualified non-elective contributions, qualified matching contributions and earnings on these contributions.
Plans have some discretion in designing hardship withdrawal provisions. For example, a plan may allow withdrawals only from elective deferrals and earnings, even though it is permitted to allow withdrawals from other sources.
What are the consequences?
Most hardship withdrawals are subject to taxes and, if you are under age 59-½, a 10% penalty. Suppose, for instance, that a 50-year-old taxpayer takes a $10,000 hardship withdrawal from a 401(k) plan. Assuming the taxpayer is in the 32% tax bracket, the amount left after federal taxes and penalties is only $5,800 ($10,000 – $3,200 tax – $1,000 penalty).
You may be able to avoid a 10% penalty if:
- You're disabled;
- Your unreimbursed medical expenses exceed 10% (for tax years 2019 through 2025) of your adjusted gross income;, or
- A court order requires you to give the money to your former spouse, a child or another dependent in connection with a divorce.
In addition to the impact of taxes and penalties, consider how permanently removing funds from your account will affect your retirement savings. Also keep in mind that, unlike most assets, the money in a 401(k) or similar tax-advantaged plan is protected from creditors. Think twice before relinquishing the opportunity to shield assets and obtain tax-deferred growth.
Are there other options?
Given the costs of hardship withdrawals, they should be viewed as a last resort. If obtainable, a traditional bank loan would be a better option. If a bank loan is not possible, find out if your 401(k) plan allows loans. Not only will you avoid taxes and penalties, but these loans offer competitive interest rates and the interest payments go back into your account. There are loan payment rules that must be adhered to however.
While these new provisions relax the rules on hardship withdrawals, it may not be the best route to take. Careful analysis should be undertaken before deciding on this course of action.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.