Sudden Emergency? Consider a 401k Hardship Withdrawal
We all know that life has a way of throwing us curve balls. They come in the form of a sudden medical emergency, a layoff, stock market correction or major home damage not covered by your insurance policy. There are a number of ways you can receive cash including selling an annuity or obtaining credit line.
But in a tighter credit environment, similar to what we saw during the Financial Crisis, this may prove difficult, or lengthy at the very least. If you’ve exhausted those other avenues you might qualify for a 401k hardship withdrawal. This is a premature distribution from your 401k account that is taxable, but avoids the penalty associated with premature distributions.
How Does a 401k Hardship Withdrawal Work?
It operates like it sounds. You may be able to access some funds in your 401k account, prematurely and without penalty, if you incur a financial hardship. This is defined as an ‘immediate and heavy financial need’ by the Internal Revenue Service.1 The following expenses from their website which are deemed to be ‘immediate and heavy’ and presumably qualify for the 401k hardship withdrawal2:
- ‘Certain’ medical expenses.
- Costs relating to the purchase of a home (primary residence).
- Tuition and other educational expenses (presumably room and board, books, lab fees, etc.).
- Adequate payments to prevent foreclosure (if owned) or eviction (if a rental).
- Funeral and burial expenses
- Certain expenses for necessary repairs on a principal residence
These parameters also apply to your spouse or minor child. The IRS website uses the example,’if you don’t have any liquid assets but your wife has a painting that can be sold for $10,000 to meet the immediate and heavy need, you probably wouldn’t qualify’.3 So now that you know what expenses generally qualify for a hardship withdrawal, let’s look at whether you can qualify for the hardship withdrawal.
To qualify, you should have no other assets that can be used to pay the immediate and heavy expense, or access to capital from outside sources. You also must have exhausted any allowable withdrawals from the retirement plan and have been turned down for funding from 401k loans, if applicable. To qualify, the employer sponsoring the 401k must not have actual knowledge that the following conditions exist that can relieve the employee’s hardship:4
- Insurance coverage
- Liquidation of employee assets (including savings)
- Stopping elective contributions to the plan
- Borrowing from ‘commercial sources’ such as a bank or other type of specialty finance company.
If you qualify for the hardship distribution you will pay the tax on gains in the account (as ordinary income) but not ‘extra tax’, also known as the penalty. But while you will owe taxes for the distribution, the taxes or penalties incurred from said distribution may also be qualified expense. According to the IRS, the maximum amount of a hardship withdrawal is equal to the total elective contributions into the plan, including Roth contributions.5
Check with your 401k Plan First
You must first check and see if your 401k plan provides for hardship distributions. Many plans have this feature, so find your plan documents or call the plan sponsor to see what circumstances constitute a hardship withdrawal. Some plans will allow for them while other plans will not.