Hardship Withdrawals Give Access to Your 401k Savings, but at a Cost
In addition to tough federal rules, you may also have to contend with a strict set of withdrawal rules from your employer.
Employers use one of two methods to issue financial hardship withdrawals. One is a proof of need. In this case, you have to show your employer financial proof that you need to take money out of your 401k. With this method, you are allowed to start contributing to your 401k plan with the next paycheck following your hardship withdrawal.
Many employers don't use this method because they really aren't interested in knowing so much about their workers' private lives. Similarly, few workers are comfortable exposing their finances to their bosses and co-workers.
The other method, called self-certification, doesn't require you to disclose your finances, but plans using this method will not allow you to make fresh 401k contributions for six months after taking the withdrawal. This further limits your ability to build a retirement nest egg.
Contact the plan administrator in the personnel department of your employer to find how if your plan offers hardships and what method they use.
Remember, once you take the money out of your plan using a hardship withdrawal, you can't put it back in and you lose for life the tax advantage on those funds.
A hardship withdrawal is not a loan. You can't repay it. But, that raises a good point. You should see if your plan offers a 401k loan as an alternative to taking a financial hardship withdrawal. Plan loans are not subject to taxes or penalties, and you can continue to contribute to the plan while you repay the loan. (Some plans will even require you to exhaust your possibilities for a loan before taking a hardship withdrawal.)
However, if you leave your employer before the loan is repaid, you must pay back the remaining balance otherwise it will be considered a withdrawal and subject to applicable taxes and penalties.
When looking for hardship withdrawal alternatives, don't forget savings in your IRA, if you have one. IRS rules allow IRA holders to withdraw up to $10,000 penalty-free when the money is used for qualified first home expenses. (That is a lifetime limit.) Also, you may take penalty-free IRA withdrawals when the savings are used to pay for qualified higher education expenses for you or your spouse, children or grandchildren.
What many 401k participants, desperate for money, may forget is the cost of taking a financial hardship withdrawal. A $10,000 withdrawal does not equal $10,000 in your pocket.
If you are under 59 1/2, you will lose 35 percent to 45 percent of the withdrawal in taxes and penalties. You need to think about that.
For example: suppose you fall in the 28 percent tax bracket.
If you take a $10,000 hardship withdrawal to pay for your child's college tuition, you will owe $2,800 in federal income taxes and an additional $1,000 to cover the early withdrawal penalty. You'll be left with $6,300, or even less if you also owe state and local income tax.
Taking a hardship withdrawal can also result in longer-term pain -- a less generous retirement.
Take the example of a person who, starting at age 30, contributes $5,000 a year to her 401k plan. At age 40, she buys a house and takes a $10,000 hardship withdrawal for the down payment. Let's assume her portfolio generates an average annual return of 8 percent. By retirement at age 65, she will have $793,094. Had she not taken the hardship withdrawal she would have had $861,584, or $68,490 more.
A $10,000 withdrawal may seem insignificant today, but over time it can mean a lot.
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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.