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Hardship 401(k) Withdrawal – Qualifications & Taxes

401k hardship withdrawal
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Hardship 401(k) Withdrawal Defined

A hardship 401(k) withdrawal is a distribution that you make from your 401(k) plan in the case of immediate, financial hardship that cannot be satisfied through any other means.

A 401(k) is designed as a savings tool to put money away for your retirement. With a 401(k) Plan, as you may already know, you cannot take out a withdrawal unless your employment ends (with a Solo 401(k), you can borrow a loan). In some cases, your plan may allow hardship 401(k) withdrawals which allows you to withdraw funds before 59 1/2 years of age. How do you determine if your plan allows hardship withdrawals? Talk to the plan administrator at your job.

Make a Withdrawal Only When it’s Necessary

Of course, withdrawals are usually discouraged unless you’re in dire straits. A hardship 401(k) withdrawal is when you take money from your 401(k) plan that is, according to the IRS, “made on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need.” You are, however, allowed to take out more than one 401(k) hardship withdrawal.

In order to withdraw funds from your 401(k), you must be able to show you are in hardship. This involves some paperwork to prove the extent of your hardship. You will then provide this information to your plan administrator. Also, be sure to adequately explain your hardships. Situations that are allowable to take a hardship 401(k) withdrawal include, but are not limited to the following:

  • eviction
  • foreclosure
  • funeral expenses
  • medical expenses (not covered by your insurance)
  • difficulty paying for your basic living expenses

401(k) Hardship Withdrawal Taxes

There are many factors to consider before you speak to your plan administrator about the hardship withdrawal. One primary concern to consider is that this withdrawal is like any withdrawal if you’re under retirement age. In other words, you have to pay taxes on your withdrawal and a potential 10% withdrawal penalty. You should never take out funds before you reach retirement age, which is 59 1/2. Also, you won’t be able to pay back the withdrawal.

Important Factors to Consider

You cannot make a contribution to your 401(k) plan for six months prior to a hardship 401(k) withdrawal. The reason for this is, if you are in desperate need of funds, then you shouldn’t be financially capable of making an immediate investment into your 401(k) retirement plan. This permanently reduces your retirement savings.

New 2019 401(k) Hardship Distribution Rules

More specifically, BBA and the Treasury Department’s proposed regulations would yield the following important changes, effective beginning in 2019 plan years—that’s January 1, 2019, for calendar year plans!

How does this affect your clients?

For plans that allow hardship distributions, as of the first day of their 2019 plan year, the following changes will require your clients to make some decisions about operating their hardship distribution program. In the longer term, they will have to amend their plan to reflect their plan operations. If your client’s plan does not allow for hardship distributions, these changes will not apply unless they choose to add that feature later.

1. The requirement to take a plan loan before making a hardship distribution will be eliminated.

  • As of the first day of a plan’s 2019 plan year, plan loans do not have to be taken before a hardship distribution.
  • Plans will still have the option to impose this additional condition.

2. Additional money types will be available for hardship distributions.

  • As of January 1, 2019 (for calendar-year plans), earnings on employee deferrals, qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), employer actual deferral percentage (ADP) safe harbor and qualified automatic contribution arrangements (QACA) safe harbor contributions, and earnings on all these amounts may be included in hardship distributions.
  •  A plan may decide not to allow these assets to be taken for hardship reasons.

3. Suspension of elective deferrals when granting hardship distributions will no longer be required.

  • As of the first day of 2019 plan years, a suspension of employee deferrals and employer contributions is not required when granting a hardship distribution; this must take effect for distributions taken on, or after, January 1, 2020.
  • In transition, participants whose employee deferrals are under a six-month suspension can resume deferring as early as the start of 2019 plan years, even if that results in a shortened suspension period; this will be a plan option. The Internal Revenue Service (IRS), in light of the timing of the publication of the proposed regulations, is granting a transition period leading up to the mandatory change on January 1, 2020.

If your client’s plan does not allow for hardship distributions, these changes will not apply unless they choose to add that feature later.

What actions do you need to take?

As Prototype Document Sponsor, one of your responsibilities is to notify your clients of law changes affecting the compliance or operation of their plan. You should notify your clients of the hardship distribution rule changes as soon as possible as your clients are required to operate their plans according to the new rules beginning January 1, 2019

What actions do your clients need to take?

Your clients must complete the following tasks.

  • Determine how they want to operate their retirement plan relative to items 1-3 above and update their hardship distribution approval and operational processes accordingly.
  • Ensure that for any hardship distributions made on or after January 1, 2020, the participant “must represent[s], in writing” or other acceptable form, “that he or she has insufficient cash or other liquid assets to satisfy the [financial] need.”

Is a 401(k) Hardship Withdrawal the Best Option?

Industry professionals say that a hardship 401(k) withdrawal should be your last resort, when all other alternatives have been exhausted. The reason for this is, with a 401(k) hardship withdrawal, you are taking out money that is tax-deferred. Additionally, this permanently reduces the amount of your retirement account and you will miss out on compound interest. The importance of compound interest is that you earn interest on the money you have saved and invested. Therefore, your interest grows at a faster rate. Let’s not forget, it’s growing tax-free each year. Rather than take our a 401(k) hardship withdrawal, consider other avenues. Try the following first:

  1. You can apply for an unsecured personal loan, which allows you to borrow money for any purpose.
  2. If you are no longer with your former employer, you can take out a regular IRA withdrawal. First, you have to roll your 401(k) account over to an IRA.
  3. Roth IRA withdrawal is a good avenue, as it’s made with after-tax dollars. Therefore, you can make withdrawals without tax or penalty. It is highly advised to take money from a Roth, if you have one, as opposed to your 401(k).
  4. Lastly, you can opt for a 401(k) loan, if your plan allows it. You pay yourself back (along with interest) and the new rules stated above makes this option easier than ever.

You should speak with your plan administrator who can help you better understand the hardship distribution options available based specifically on the applicable 401(k) plan document. Since all 401(k) plans are different, make sure you know all available avenues you can explore.

Get in Touch

For more information on the hardship 401(k) withdrawal, contact IRA Financial Group. We are happy to assist you.

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