When to Consider a 401(k) Hardship Withdrawal

By Clay Wyatt

A 401k hardship withdrawal is an early withdrawal from your 401(k) that may or may not be permitted by your employer under certain circumstances. If your employer 401(k) plan permits you to take a 401(k) hardship withdrawal, it must do so in accordance with IRS guidelines. Generally, the reason for withdrawing the funds must involve a heavy financial need. When should you consider a 401k hardship withdrawal? The answer depends on whether you may legally do so and how desperate you are.

The following are circumstances in which you are permitted to take a 401(k) hardship withdrawal under IRS guidelines. Note that there are details involved to qualify for each of these circumstances so consult with a financial or tax advisor first before proceeding:

-  To pay for medical expenses that exceed 7.5 percent of adjusted gross income.

-  To pay for costs related to the purchase of a principal residence.

-  To pay for educational expenses.

-  To prevent a foreclosure or eviction from a principal residence.

-  To pay for burial and funeral expenses.

-  To pay for repairs to your principal residence.

Now, just because you are legally permitted to take a 401(k) hardship withdrawal doesn't necessarily mean you should do so. Any funds that you take out in a 401(k) hardship withdrawal will be taxed as ordinary income and they do not have to be repaid. Also, if you are under age 59 ½, you'll have to pay a 10 percent penalty on your withdrawal. While the money will be taxed in the future if you leave it in there, taking a 401(k) hardship withdrawal negates one of the primary purposes of a 401(k), which is to have tax-deferred growth on your investments. Not only that, but if you do not repay the money, then you forfeit any future earnings (or losses) you would have had on the amount you withdrew. With the stock market averaging 10 percent in gains annually, that will likely add up to thousands of dollars in earnings that you give up when taking a 401(k) withdrawal if you are unable to pay it back.

If your 401(k) plan allows loans, it may be best to take a loan instead of taking a 401(k) hardship withdrawal. In this case, you can borrow up to 50 percent of your vested amount. The rules are similar to those of a 401(k) hardship withdrawal. This will not be taxed as ordinary income as long as you pay it back within 5 years in most cases. In the case of using a loan from your 401(k) plan for a down payment on your first home, you will have up to 15 years to pay it back. While this might seem like a great option, remember that you will have to pay this back to avoid penalties and, if you leave your employer, you may have to pay the money back in a short period of time. As is the case with most other loans, failure to meet the payment terms will also cause problems. Check with your employer or plan administrator for details before deciding to go this route.

Essentially, taking a 401(k) hardship withdrawal should be a last resort due to the potential forfeiture of earnings and myriad of problems that could occur if you are unable to successfully pay it back. By all means, if you have other, less-complicated options to pay for an immediate, necessary expense, explore them first. If you truly feel that taking a 401(k) hardship withdrawal is the only means of avoiding an eviction, bankruptcy, or other serious problem in life, then make sure you talk it over with a qualified financial advisor. Failure to do so may make a serious problem a whole lot worse and cause financial problems during your retirement years.

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