So, we all know that 401ks are meant for retirement savings. But we also all know that once in a blue moon, a situation arises – a big unexpected medical bill, lingering credit card debt, or a down payment on a home – where we kind of wish we could tap some of those funds in our 401ks.
Before we dive in, I’m going to say this right upfront: it’s really never a good idea to take money from your retirement fund if you can possibly help it. Early withdrawals can carry hefty penalties and taxation, and you can rob yourself of the power of compounding interest if you take funds out of your 401k that could otherwise be growing.
But that being said, if you do find yourself in a situation where it’s really unavoidable to withdraw funds from your 401k early, there is something called a “401k hardship withdrawal” that might allow you to use your contributions without penalty.
It’s up to the plan sponsor to decide whether to allow hardship withdrawals; however, most 401k plans do allow participants to make these kinds of withdrawals.
What is a “Hardship Withdrawal”?
As the name implies, 401k hardship withdrawals are designed to let participants withdraw money from their retirement plans if they’re facing some kind of financial hardship. But the IRS’ definition of “hardship” is rather broad. Hardship withdrawals are currently allowed for one of the following reasons:
- Medical expenses incurred by the participant or the participant’s spouse, dependents or beneficiaries.
- The purchase of a home if the home will serve as a primary residence, not an investment property.
- To prevent eviction from or foreclosure on a primary residence.
- Funeral expenses for the participant or the participant’s spouse, dependents or beneficiaries.
- Tuition and related expenses (such as fees and room and board) for the next year of post-secondary education for the participant or the participant’s spouse, dependents or beneficiaries.
- Expenses that are necessary to repair damage to the participant’s primary residence.
Drawbacks of Making Hardship Withdrawals
Keep in mind, however, that just because you are facing one of these financial hardships doesn’t mean that taking out a hardship withdrawal is a smart financial move. There are several potential drawbacks to making hardship withdrawals.
Perhaps the biggest disadvantage is that regular income taxes will be due on the funds taken out during the year in which they’re withdrawn. And if you’re under age 59½, a 10% early withdrawal penalty may also apply. There are a few exceptions to the early withdrawal penalty, including disability, medical debt that exceeds 7.5%t of adjusted gross income (AGI), and a court order to give money to a divorced spouse, child or dependent.
If you don’t qualify for one of these exceptions and you are under 59½ years old, you could receive significantly less money than the amount you take out via a hardship withdrawal. For example, if you’re in the 22% tax bracket and make a hardship withdrawal of $10,000, you’ll only put $6,800 cash in your pocket after subtracting $3,200 in taxes and penalties.
Another big drawback to making hardship withdrawals is that this could jeopardize your ability to enjoy a financially comfortable retirement. Every dollar withdrawn from your 401k early is a dollar that isn’t there for retirement. In addition, you lose the opportunity for these funds to grow on a tax-deferred basis over the long term, which could potentially grow your nest egg even more.
Our Take: A Last Resort Financing Option
In most instances, 401k hardship withdrawals should be considered a last resort for obtaining funds, even if a particular situation qualifies as a hardship. The taxes and penalties associated with hardship withdrawals and the impact such withdrawals may have on your retirement finances can make them an expensive source of funds.
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