When times are tough and household budgets are under severe strain, taking cash out of your 401(k) plan can provide some relief. However, it’s best to be cautious, as there are specific rules related to when you can and cannot take 401(k) withdrawals. Additionally, you must meet certain criteria to avoid penalties when withdrawing funds early from your retirement account.
Here’s what to know when considering a 401(k) hardship withdrawal:
— What is a 401(k) hardship withdrawal?
— Reasons for a 401(k) hardship withdrawal
— 401(k) hardship withdrawal rules
— Pros and cons of hardship withdrawals
— Recovering financially from a hardship withdrawal
— Alternatives to a 401(k) hardship withdrawal
[Related:What Is the Average Retirement Savings for Gen X?]
What Is a 401(k) Hardship Withdrawal?
Most 401(k) plans allow withdrawals starting at age 59 1/2. However, some plans allow participants who are experiencing a hardship to take money from their retirement account before reaching the eligible withdrawal age, typically due to an immediate financial need. Individuals who take distributions before that age usually have to pay a 10% penalty and income tax on the amount withdrawn. If specific hardship requirements are met, you could avoid paying the 10% penalty.
Good Reasons for a 401(k) Hardship Withdrawal
The Internal Revenue Service allows a 401(k) hardship withdrawal if you have an immediate and heavy financial need. According to the IRS, the following situations might qualify for a penalty-free 401(k) hardship withdrawal:
— Certain medical expenses
— Burial or funeral costs
— Costs related to purchasing a primary home
— College tuition and education fees for the next 12 months
— Costs required to avoid a foreclosure or eviction
— Home repair after a natural disaster
“Hardship withdrawals should only be used when all other options have been explored or used, such as loans, emergency savings or assistance programs,” said Dustin Alexander, founder of Stirling Capital in Oregon, Ohio, in an email. “Using withdrawals from a retirement plan to fund discretionary spending, like vacations or non-essential purchases, is generally an unwise plan. Not only will it cost you additional income taxes, but the lost growth potential can set your retirement back by years.”
[Related:10 Strategies to Maximize Your 401(k) Balance.]
401(k) Hardship Rules
There are multiple rules and guidelines attached to a hardship withdrawal, with these factors at the top of the list.
— Eligibility. Withdrawals typically can be made after reaching age 59 1/2 without penalties. Early withdrawals may incur a 10% penalty in addition to the income tax due. “There are some exceptions, such as hardship withdrawals, first-time home purchases and education or medical expenses,” Alexander said.
— Tax implications. Withdrawals from traditional pretax retirement accounts are taxed as ordinary income. “Roth accounts may allow for tax-free withdrawals of contributions, but not on earnings, under certain circumstances,” he noted.
— Plan variations. Retirement plans are unique and come with specific rules. “For example, some 401(k)s allow for both hardship withdrawals and loans, while others only allow for hardship withdrawals,” Alexander added.
Pros and Cons of Taking a Hardship Withdrawal
As with any personal financial decision, there are advantages and disadvantages to 401(k) hardship withdrawals.
The Pros
— A hardship withdrawal can help you pay for emergency expenses without going into debt.
— When withdrawals from a 401(k) plan are made before reaching age 59 1/2, a 10% penalty applies. However, this penalty is waived with a qualified hardship withdrawal.
— Unlike 401(k) loans, you are not required to pay back a hardship withdrawal.
The Cons
— Hardship withdrawals are reported as ordinary income, which can increase the tax burden of the 401(k) owner.
— Withdrawals may permanently reduce retirement savings and disrupt the progress of compounded growth.
— Your account contributions may be temporarily suspended for six months after a hardship withdrawal, depending on your plan rules.
[Read: How to Save in a 401(k) and IRA in the Same Year]
Making Up Ground After Taking a Hardship Withdrawal
To financially recover from a 401(k) plan hardship withdrawal, resume contributions as soon as possible after your withdrawal is made.
“Ideally, aim to increase contributions where you can, like when you receive a bonus or pay increase,” said Christine Lam, a certified financial planner at Financial Investment Team in Portland, Oregon, in an email. “For those who are over the age of 50, take advantage of allowable catch-up contributions. Review your budget and adjust expenses to allow yourself to save and pay yourself first.”
If all options have been explored and you move forward with a hardship withdrawal, planning becomes even more essential to make up the loss. There are several ways to make up the lost ground:
— Cut expenses. By curbing the household budget, you can build an emergency fund to avoid similar situations in the future.
— Maximize employer match. If you’re not already putting the full company match into your retirement plan, do so immediately. “It’s free money from your employer,” Alexander said.
— Take advantage of catch-up contributions. If you’re 50 or older, you can contribute an additional $7,500 per year into your employer-sponsored retirement plan.
The Best Ways to Avoid Taking a Hardship Withdrawal
If possible, leave your retirement fund intact and opt for another cash withdrawal strategy. This is why it’s so crucial to establish emergency savings.
“Although some hardship withdrawals are due to unforeseen circumstances such as a large medical bill or disaster-related home expenses, having some form of emergency savings will reduce the amount needed from any hardship withdrawal,” Lam noted.
If the expense is related to purchasing your first home, consider exploring first-time home buyer programs to help offset the cost or save more. “In addition, depending on the financial situation, potentially borrowing on a (home equity line of credit) of your residence or some other type of loan may make more sense than withdrawing from your retirement nest egg,” Lam said.
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When a Retirement Hardship Withdrawal Makes Sense originally appeared on usnews.com
Update 07/16/25: This story was published at an earlier date and has been updated with new information.