Hardship withdrawals: What you need to know

When you're in a financial bind, a hardship withdrawal from your 401(k) may be an option.

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When it rains, it pours—and sometimes the only umbrella available is in your 401(k). Having the option to take a hardship withdrawal from your retirement account can be a lifesaver when you have nowhere else to turn for cash.

But before you take a hardship withdrawal from your 401(k), evaluate all your options carefully. If you really have to do it, take steps to help reduce the damage to your retirement and make a plan to get your finances back on track.

Limited allowable circumstances

There may be a few hurdles to cross before you can take a hardship withdrawal. First, your plan has to allow them—not all do. If your plan does, many companies require that you take a loan from your 401(k) first. After that, a hardship withdrawal or early distribution from your 401(k) may be available for certain circumstances.

Unfortunately, it is an expensive way to get money. Taxes and penalties can eat up part of your cash, plus you may lose the long-term benefits of tax-advantaged compounding—and that could reduce the money you will have available in retirement. Unlike taking a loan from your 401(k), you can’t repay a hardship withdrawal. You may even be required to wait six months following an early distribution before you can begin contributing to the account again. The suspension also applies to any other qualified, nonqualified, and stock plans of all related employers.

For those plans that allow hardship withdrawals, there are two ways of handling them—it depends on the way the plan was initially set up—and some plans offer both choices.

#1. Hardship withdrawals allowed under the "safe harbor" standard

If your plan uses the safe harbor method for determining whether an immediate and heavy financial need exists, the following circumstances1 qualify for hardship distributions:

  • Unreimbursed medical expenses for yourself, or for your spouse, dependents, or beneficiaries
  • Costs relating to the purchase of a principal residence
  • Tuition and related educational fees and expenses for the next 12 months of postsecondary education for yourself, or for your spouse, dependents, or beneficiaries
  • Funeral expenses
  • Payments necessary to prevent eviction from or foreclosure on your home
  • Certain expenses for the repair of damage to your principal residence

#2. Hardship withdrawals depending on "facts and circumstances"

Using this distribution method, the plan administrator will consider the facts and circumstances of your case to determine whether an immediate and heavy financial need exists. The plan administrator may ask for documentation showing the need, and for you to prove that you have no other options, or may allow you to write a letter certifying that.

Steep penalty

If you are under age 59½, the distribution from your account will probably be subject to a 10% penalty, and is generally considered taxable income for state and federal tax purposes—which means it will be taxed at your ordinary income rate. There are some circumstances that qualify for a penalty-free withdrawal, however, including disability and unreimbursed medical bills greater than 7.5% of adjusted gross income.

  • Visit IRS.gov to find out more about exceptions to the 10% tax on early distributions.

Taxes and opportunity costs

Taxes can take a big bite out of early withdrawals. Someone in the 25% tax bracket2 may potentially owe the IRS 35% of the amount of the withdrawal, including the 10% penalty. So, for example, in order to get $10,000 in your pocket, you’d have to take out $13,500 to cover taxes and penalties—if your plan allows you to take additional money to pay for taxes. Not every plan will allow that, so you may need to have another source of funds to cover the tax liability. Check with your plan administrator to understand what is allowed under your plan.

If your withdrawal comes from Roth contributions, you likely won’t have to pay income taxes—unless part of the distribution comes from employer contributions. It can be complicated, so check with your tax expert to ensure you don’t over- or underpay taxes due.

But taxes and penalties are only the immediate costs. The opportunity costs from lost investment returns on that withdrawal can add up over time.

Dos and don'ts

Taking money from your 401(k) should be a last resort, reserved for a serious emergency.

Don’t take a withdrawal lightly.
Make sure you have thoroughly explored all your other options.

  • Read Viewpoints: "How to save money."

Do consider going into emergency saving mode.
Take a look at your spending. There could be a lot of fat to cut out of your budget. No one enjoys a spending diet, but temporarily slashing spending could help you avoid taking a hardship withdrawal or reduce the amount you need to take out.

Do evaluate your other options.
If you’re a homeowner and have good credit, taking out a home equity loan or line of credit may be a possibility. If you were thinking of taking money out to pay for your children’s education, consider student loans for part or all of their education. After all, there are no loans to cover retirement.

Do consider a 401(k) loan instead.
In some cases, you have to take a loan from your 401(k) before you can take a hardship withdrawal. In other cases, it’s an option. Either way, a 401(k) loan could be a better, though still costly, option than a hardship withdrawal, as you will pay the money back to yourself with interest.

Do consider taking a distribution from a traditional or Roth IRA instead of taking a 401(k) hardship withdrawal.
You may have a little more flexibility with a Roth IRA than with a 401(k).

Contributions to a Roth IRA can be withdrawn any time, tax and penalty free. Distributions of earnings are subject to a potential 10% penalty. A limited number of circumstances qualify for a penalty-free distribution from a Roth IRA. Among them are first-time home purchases—or if it’s been two years since you owned a principal residence—qualified education expenses, and disability.

All early distributions from a traditional IRA are potentially subject to income tax and the 10% penalty. Like the Roth IRA, there are a few cases when you can take a penalty-free distribution. For instance, if you’re buying a house as a first-time homeowner or it’s been two years since you last owned a principal residence, you can take an early distribution of up to $10,000 without paying the 10% penalty—but you’ll still have to pay taxes on the amount withdrawn.

Even though it may be easier and less costly to withdraw from an IRA than a 401(k), any withdrawals will lose the benefits of tax-advantaged compounding over time.

Beef up your emergency fund and get back on track

Everybody makes financial mistakes or experiences setbacks—it’s how you respond to obstacles that will help you achieve your goals. If you do find yourself in a situation where you have to take money out of your 401(k), don’t despair or give up. Get yourself back on track by building a solid emergency fund to help ensure that you’re covered for unforeseen expenses. We suggest saving at least three to six months’ worth of expenses in your rainy-day fund.

As soon as you’re able, start contributing as much as you can to your retirement account—even if it’s a small amount. Work toward bumping up that contribution when you can. We believe you should be saving at least 15% of your income each year.

The important things are to have a plan and to keep saving for retirement—you’ll eventually get back on solid financial footing.

Learn more

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Investing involves risk, including risk of loss.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and are subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
1. Source: IRS.gov.
2. 2016 tax brackets (for taxes due April 17, 2017), Bankrate.com.
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