If you are faced with a major financial hardship, you might be tempted to make an early hardship withdrawal from your 401(k) retirement account with your employer. In general, a hardship withdrawal before you are 59 1/2 years old will be subject to income tax plus a 10 percent early withdrawal penalty, but there is a limited set of hardship circumstances for which you can escape the 10 percent penalty.
The Internal Revenue Service's distribution regulations for 401(k) plans provide for hardship withdrawals to meet an “immediate and heavy” financial need. You must have no other way to meet the need because you have exhausted all your other resources, and you are withdrawing only enough to meet your need. If you make a hardship withdrawal, you won’t be able to contribute anything to the 401(k) for six months after the withdrawal.
The 401(k) rules define a hardship as unreimbursed major medical expenses, purchase of your principal residence, payment of college tuition and related expenses including room and board, payments to a landlord to prevent eviction or to a mortgage holder to prevent foreclosure, funeral expenses, and payment of unreimbursed costs to repair damage to your principal home caused by a fire or other disaster.
If you suffer certain hardships, the 401(k) rules waive the 10 percent early withdrawal penalty. Those circumstances include unreimbursed medical bills exceeding 7.5 percent of your gross income, if you become totally disabled, or if you are subject to a court order requiring you to give 401(k) money to a divorced spouse or child or dependent. You will also avoid the 10 percent tax penalty if you are over age 55 and withdraw money from the 401(k) because you lost your job. And you won't owe the penalty at any age if you lose your job but set up a schedule of equal payments from the 401(k) over the course of your life expectancy.
The IRS 401(k) rules leave it up to each employer whether to permit hardship withdrawals. If an employer allows such withdrawals, it doesn’t have to permit all the 401(k) hardship withdrawal grounds allowed by the IRS. An employer might permit hardship withdrawals because of medical bills or home foreclosure but could deny hardship withdrawals for college expenses. The IRS rules also leave it to the employer whether to require that the employee prove he faces financial hardship or to simply take the employee at his word that a qualifying hardship exists.