Everything You’ve Ever Wanted to Know About a Hardship Withdrawal
When people dip into their retirement plans before the age of 59 ½, it’s usually to cover a big financial hit. Among the most common reasons are out-of-pocket medical costs, down payment on a principal residence, burial and funeral expenses, and educational expenses. Dipping into your retirement plan before age 59 ½ is known as a hardship withdrawal, and is nearly always the last resort (withdrawing early means you'll pay a penalty fee).
With the price of everything, from health insurance to college tuition on the rise, it's not surprising that 2.2% of all 401(k) participants made a hardship withdrawal between August 2017 and August 2018. If you ever find yourself having to consider this option, it's important to be armed with the information you need to make the right choices.
Hardship Withdrawals: A Crash Course
What is a hardship withdrawal?
Unlike borrowing money from your retirement plan, a hardship withdrawal is just that: a permanent withdrawal from your retirement plan that you don’t pay back. It means that you are experiencing extreme financial need that can only be satisfied by a distribution from your retirement plan.
What are the rules for 401(k) withdrawals?
As with all things financial, there are rules about when and how you can withdraw funds from your retirement plan. Among the most notable are these:
- It is up to your employer to determine the specific criteria for a hardship withdrawal1. For instance, one plan may consider a medical expense, but not college tuition, to be a financial hardship.
- The reasons for making a hardship withdrawal are few and far between. Even if you have IRS approval, your employer doesn’t necessarily have to go along with it. Among the most common reasons are college tuition due in the next 12 months, a down payment on a home, out-of-pocket medical expenses, expenses for home repair to cover damage by flood, fire, hurricane or earthquake, or to prevent foreclosure or eviction.
- There are limits to how much you can withdraw. You can only request the amount needed to cover the expense. This includes any taxes or penalties you pay on the early withdrawal.
- IRAs are different. Unlike a 401(k), you don’t need approval to dip into a traditional IRA before the age of 59 ½. You’ll always pay taxes on the amount you withdraw, but you may be able to dodge the 10% early withdrawal penalty if your distribution qualifies as an exception. Among these exceptions are higher education expenses for you or your immediate family, a first-time home purchase, medical expenses and permanent disability, among others.
How does it work?
If your employer-sponsored retirement plan allows hardship withdrawals, you’ll probably need to submit a request. That request then has to be approved by a committee or a representative who has accepted responsibility for making the decision to allow you to make the withdrawal—or not.
It shouldn’t come as any surprise that the approval process can be tough. Plans that allow hardship withdrawals are legally required to spell out their specific rules. You may have to explore alternatives like a commercial loan or an IRA withdrawal before your employer will consider an application a hardship withdrawal. They may even ask you to provide financial statements, medical bills or a notarized statement as proof that you need the money.
In February 2018, Congress passed the Bipartisan Budget Act (BBA), which, starting in 2019, will make it easier for you to make hardship withdrawals from your retirement plan2. Among the changes is one that allows you to withdraw not only your contributions to your retirement plan but also your employer’s contributions plus investment earnings.
Moreover, both you and your employer can keep contributing to your plan. This shift away from the punitive six-month contribution suspension is designed instead to help you maintain and grow your retirement savings. In addition, you don’t have to explore plan loan options before deciding that a hardship withdrawal is what you really want.
But not all the rules are new. One provision that has been around a while but doesn’t always make the headlines is the IRS Rule of 55. Essentially, if you are laid off or fired, or you quit your job between the ages of 55 and 59 ½ you can pull money out of your retirement plan without paying the 10% penalty. Keep in mind that this rule only applies to your current plan. If you have money in a retirement plan at a previous employer, not your current employer, you’ll have to wait until you’re 59 ½ to withdraw those funds – or pay the penalty.
The pros and cons
The number-one reason for withdrawing money from your retirement plan is having the money. You can pay the bills, keep the house, pay for medical treatments or cut a check for that college tuition. Yes, it will cost you to make that withdrawal. Yes, you’ll pay income taxes on the amount you take out. But you will have the money you need. And that’s pretty much the biggest advantage of a hardship withdrawal.
The downsides are more numerous. In addition to depleting your retirement account, there are taxes to consider, along with penalties, individual plan differences and hiccups (each plan has its own complexities) and, maybe most important of all, opportunity costs. Withdrawing money from your retirement plan is a permanent reduction in the value of your nest egg. Why? You lose the benefits you reap from tax-free compounding. And if you’re lucky enough to have an employer-match plan, then you’re losing out on even bigger growth in your retirement funds.
A last resort
If you’re struggling financially or have racked up some unexpected expenses, it’s important to consider all your options before deciding to raid your retirement account in a permanent way. Most financial experts will say that a hardship withdrawal should be a last resort. If you have exhausted all your options and come up empty-handed, maybe it’s time to talk to a financial planner or advisor. Any steps you can take to protect your financial future – and the money you’ve worked hard to save – will be worth it.