401khelpcenter.com Logo

Emergency Access to Your 401k: Hardship Withdrawals

    

(Cont...)

If the plan administrator allows frivolous withdrawals, "it's a plan-level problem that could result in the plan being disqualified," said Stone. Each plan that allows hardship withdrawals is required to spell out its own rules in the plan document. These rules can be tougher than the federal guidelines.

You may be required by your plan to explore several alternatives before you are approved, such as an IRA withdrawal or a commercial loan. Many plans require you to provide some sort of proof to document your financial need. This can include financial statements, eviction notices, or a notarized statement from an accountant. "Hardships are strictly for immediate and very heavy financial burdens," said Stone.

Remember that when you've been approved for a withdrawal, you're not off of the IRS radar screen. A hardship withdrawal is a taxable event, so you will have a mandatory 20 percent withholding tax taken out of the check. You may end up owing more, depending on your total income for the year. You may also be subject to the 10 percent penalty if you are under age 55.

The Pain of Paying Penalties

The tax burden on early withdrawal hits you in two different ways. First, your withdrawal is subject to ordinary income tax. For example, if you normally pay 28 percent federal tax and 4 percent state tax, then a $10,000 hardship withdrawal will lose $3,200 to the government.

Second, your withdrawal may be subject to a 10 percent early withdrawal penalty on the full amount. The only reason you wouldn't pay the penalty is if you are over age 55 or if the IRS grants you an exemption. Even though, in our example, you are paying $3,200 in taxes already, you still pay the 10 percent penalty on the full amount, or a penalty of $1,000. Put these two numbers together and you can see that the $10,000 withdrawal only leaves you with $5,800 after taxes. On average, you'll pay between 25 percent and 40 percent or more in taxes and penalties from your hardship withdrawal, according to retirement expert Ted Benna.

"These kinds of withdrawals are a very real loss to your retirement goals," said Stone. "When you use investment dollars today, you are also using the future gains that the money could have earned. It could have a very sizeable impact."

Will My Retirement Plan Survive?

While it may not be your primary concern at the time, the withdrawal will hurt your retirement savings in several ways. Your withdrawal will cost you not only the taxes on the money you take out, but also the compounded earnings that you would have made on that money. Plus, when you take a hardship withdrawal, you won't be allowed to contribute to your tax-deferred retirement plan for 12 months.

For example, a person who began contributing $5,000 per year at age 30 and took a hardship withdrawal of $10,000 at age 40 will have missed out on $173,355 at age 65, assuming a consistent 10 percent annual return. That amount could give you an annual income of between $10,000 and $15,000 for 20 years after retirement, depending upon how it was invested.

If your financial situation has been so difficult that you've needed a hardship withdrawal, it probably isn't a bad idea to take some time rebuilding your short-term savings after you've dealt with the crisis. Most financial planners say that you need three to six months worth of income in liquid short-term investments, like savings or money market accounts.

Repairing the Damage

After taking all of this into consideration, if you still want to take a hardship withdrawal, there are ways you can mitigate at least some of the negative effects it can have on your retirement account. After all, there is no sense in turning your current financial crisis into a second crisis in retirement. Some ways to get back on track include:

  • Increasing the amount you would normally defer once you resume making contributions.
  • Putting money into an IRA if you recover financially from your crisis before you are eligible to contribute to a defined-contribution plan.
  • Making a catch-up contribution if you're age 50 or older.
  • Taking on a little more risk in your account. Review your asset allocation.
  • Taking a hardship withdrawal for a home purchase at the beginning of the year, so that the tax benefits of home ownership for a full year help offset the downside of an early 401k withdrawal.

These methods may not fully recover the loss incurred by your withdrawal; however, restoring to your retirement account(s) the income you withdrew is an important element in achieving your overall retirement goals.

Other Resources

401k Plan Hardship Withdrawals
Hardship Withdrawals Give Access to Your 401k Savings, But at a Cost
Don't Tap Your 401k to Pay Off Debt

< PREVIOUS Page 2 of 2

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.


Press Center | Glossary | Privacy Policy | Terms of Use | Contact Us

Creative Commons License
This work is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.