When and How To Make a 401(k) Hardship Withdrawal
9 MIN READ
Published November 23, 2023 | Updated January 11, 2024
If you’re facing an unexpected expense and have no emergency fund to rely on, you may have considered canceling your contributions to your 401(k) plan and cashing it out. However, if your employer allows it, you may be able to make a 401(k) hardship withdrawal instead, under specific circumstances.
Retirement accounts are set up so you can start withdrawals penalty-free at age 59 ½. Early distribution from a pre-tax retirement account, such as a Traditional 401(k) or Traditional IRA means you’ll owe income tax on the amount you withdraw, plus a mandatory 10% penalty.
However, if you meet the eligibility criteria for special penalty-free withdrawals, you may be able to take money out penalty-free if you’re facing financial hardship. Keep in mind, however, that you’ll still have to pay income taxes on the amount of your withdrawal, at ordinary income tax rates.
How 401(k) Hardship Withdrawals Work
You may be able to make 401(k) hardship withdrawals, without the 10% penalty, under specific circumstances, such as purchasing your first primary residence, covering funeral expenses, and to pay any medical bills you may have.
Ordinarily, any amount you withdraw from a Traditional 401(k) account will be subject to income tax and a 10% early distribution penalty, if you withdraw the funds before you reach the age of 59 ½.
In some cases, depending on the reason for the withdrawal, such as paying for qualified higher-education expenses or as a down payment for purchasing your first primary residence, this 10% penalty is waived. Some other exempted withdrawal reasons include:
- Paying for health insurance premiums while unemployed.
- To make a distribution to an ex-spouse as part of a divorce.
- The total and permanent disability of the account owner.
- The death of the account owner.
- Certain distributions to qualified military reservists who have been called to active duty.
While hardship withdrawals are not common, a growing number of Americans participating in 401(k) plans have been withdrawing from their plans in recent years. The number of participants making hardship withdrawals has increased by 36% year-over-year, following increases during the first quarter of 2023.
401(k) Hardship Withdrawal Rules
The Internal Revenue Service (IRS) only allows participants to take 401(k) hardship withdrawals due to an immediate and heavy financial need. Employers offering this option may require proof of financial hardship. Lying to get a 401(k) hardship withdrawal is fraud and can have serious consequences.
When you take the withdrawal, you’ll have to pay taxes and the additional 10% early withdrawal penalty, unless you qualify for an exemption. Your employer will also specify the requirements for withdrawals in their plan documents, but here is a summary of common-used exemptions from the early withdrawal penalty:
|10% Penalty Waived?
|Total and Permanent Disability of Account Owner
|Medical Expenses more than >10% of AGI, for you, your children, spouse, or other qualified dependents
|Funeral or Burial Expenses (Death) of Account Owner
|First-time purchase of a primary residence (up to $10,000)
|401(k)’s–No / IRA’s–Yes
|Prevention of foreclosure or eviction, or for home repairs due to a natural disaster
|Health insurance premiums while unemployed
|401(k)’s–No / IRA’s–Yes
|Educational expenses and tuition
|401(k)’s–No / IRA’s–Yes
The amount you can withdraw will depend on how much is necessary to satisfy your financial need. For example, if you have medical bills of $5,000, you can only withdraw up to $5,000 to cover those expenses.
You must also not have assets or funds elsewhere that can be used to cover the financial hardship, such as a Roth IRA account or bank CD or savings account. Unlike a 401(k) loan, you won’t have to repay the money you withdraw.
How To Know If You're Eligible
Each employer may have their own eligibility requirements for hardship withdrawals from their 401(k) plan. We recommend reaching out to your plan administrator or your employer’s Human Resources/Benefits department to determine the eligibility criteria.
Your employer can help you determine whether you have an immediate financial need that qualifies for such a withdrawal. For example, withdrawing money for a consumer purchase will not meet the IRS’s requirement for a “heavy and immediate financial need”.
Additionally, you may not qualify if:
- You, your spouse, or your dependents have assets or other funds that can be used to cover the financial need.
- In some cases, you may have to take out a 401(k) loan, before you can take a hardship withdrawal.
7 Steps To Make a 401(k) Hardship Withdrawal
It should be noted that 401(k) hardship withdrawals are generally more complex and difficult compared to 401(k) loans because of the qualification requirements. Here is a step-by-step guide on how to apply for and receive a hardship withdrawal:
- Contact your HR department or check with your employer’s plan administrator (e.g. Fidelity, Vanguard, T. Rowe Price, Empower, etc) to access a list of specific requirements to qualify and determine the exact application steps.
- Your plan may allow you to make the request online or submit it in writing.
- Fill out the form, specifically listing the reason for withdrawal.
- If your administrator requires proof, provide a copy of your notice of eviction, medical bills, or other appropriate documents.
- Submit your request and wait for the administrator to review it to ensure it meets the eligibility requirements.
- If approved, your company will send the funds via check or direct deposit within 2-3 business days.
- Make sure you save any documents that prove you’re eligible for the withdrawal in case of an IRS audit of your tax return for the year in which you take your hardship withdrawal.
What Are the Alternatives?
A hardship withdrawal is not always the best option when you need money. There may be other ways to access money from your retirement savings, depending on your retirement plan’s rules. Here are two other alternatives to consider.
With a 401(k) loan, you’ll be able to borrow up to 50% of your vested balance or up to $50,000, whichever is lower. Since you won’t be canceling and cashing out your 401(k) while you’re still employed, you won’t have to pay a penalty or income taxes on the loan amount.
You’ll have to repay the loan (plus interest on the loaned funds), typically within five years, but 100% of the payments you make will be returned to your 401(k) account, instead of to a bank. However, if you leave your job, you’ll be required to immediately repay the loan, otherwise, it will be counted as a distribution, which means you will have to pay the income tax and the 10% penalty on it, regardless of the original reason for taking the loan.
Withdraw From Your Roth IRA
A Roth IRA allows you to withdraw money, up to the full amount of the contributions you’ve made to your account to date, at any time and for any reason, tax-free and penalty-free. When it comes to withdrawals from a Roth IRA, or Roth 401(k), it is assumed your contributions and any converted Roth IRA funds come out first, and then the earnings.
As long as you do not withdraw more than the sum-total amount of your contributions (net of any previous withdrawals you’ve taken), you will not have to pay income taxes, or an early withdrawal penalty, whenever you take a withdrawal from your Roth IRA or 401(k).
For example, let’s say you have a Roth IRA account that is currently worth $40,000, to which you have made a total of $25,000 in contributions, since you opened it several years ago.
IRS rules allow you to withdraw up to that entire $25,000 from your Roth IRA, tax-free and penalty-free, because it is assumed your contributions are withdrawn first, and then your earnings. Once you take out more than the initial $25,000, you’ll be taxed and penalized on any further withdrawals after that.
401(k) Rollovers to an IRA
While a direct rollover of your entire account balance from a Traditional 401(k) to a Traditional IRA will not provide you with immediate access to any cash, it will allow you to roll the money over directly to your IRA, tax-free and penalty-free, if you do it directly, from one account to the other.
Please note, if you roll over your Traditional pre-tax 401(k) account balance to a Roth IRA, you can do that without paying the 10% early withdrawal penalty, but you will need to pay federal and any state income tax on the full amount of the rollover. You can, however, roll your Roth 401(k) over to your Roth IRA tax-free and penalty-free, because the account types are the same.
When rolling-over your 401(k), it’s important to roll the funds over to an IRA of the same type, e.g. Traditional 401(k) to Traditional IRA, or Roth 401(k) to Roth IRA. When you make sure to match account types like this, you avoid both income taxes and any early withdrawal penalties, whenever you do a direct rollover.
Compare Your Options Before a 401(k) Hardship Withdrawal
Other than the two 401(k) Loan and Roth IRA withdrawal alternatives listed above, we recommend exploring all your other options, such as taking out a personal loan or borrowing from friends or family before taking a taxable hardship withdrawal. Regardless of the income tax and potential withdrawal penalty implications, any amount you withdraw from your retirement fund will shrink your nest egg and may put your long-term retirement at risk.
Debt expert and founder and managing director of Reichert Asset Management LLC, Brad Reichert, also cautions against this option. “Financial emergencies and temporary expenses do come up from time to time, but if you choose to use your retirement savings to solve them, it may mean you’ll need to retire at a later age or at a lower income and standard of living,” Reichert says. “Once your short-term need is taken care of, it’s important to build that nest egg back up again as soon as possible,” he adds.
You may also want to consult a qualified, experienced tax advisor or Certified Financial Planner (CFP) practitioner to determine whether a 401(k) hardship withdrawal is suitable for your circumstances.