Using a tax-deferred retirement plan sponsored by your employer can be to your advantage, but these plans come with some strings attached. One of the strings is that you may have taxes withheld from a hardship withdrawal -- if your plan even allows you to make one. Many retirement plans allow hardship withdrawals, but you will face some tax liabilities.
Hardship withdrawal rules apply to 401(k), 403(b) and 457(b) retirement plans. Employers, referred to as plan sponsors, may allow hardship distributions while you are working for them, but this isn’t mandatory. Under Internal Revenue Service rules, hardship means an “immediate and heavy” financial problem. You must exhaust other financial reserves before making a hardship withdrawal and the purpose must fall under IRS “safe harbor” rules. Examples of a safe harbor hardship withdrawal include medical expenses, buying or repairing your primary residence, paying tuition and preventing eviction or foreclosure. With a 457(b) plan, the need must be unforeseeable, which eliminates buying a home and paying tuition.
The IRS does not require any tax withholding for a hardship withdrawal, although you might have 20 percent taken out for a rollover to another retirement plan. Your retirement plan may withhold taxes unless you choose otherwise. For example, Fidelity Investments withholds 10 percent of any hardship distribution unless you specify a different amount. The IRS allows you to include all expected taxes as part of your hardship distribution. For example, under safe harbor rules you might be able to take out $2,500 for medical expenses. If the expected tax liability resulting from this withdrawal is $1,000, you can take out $3,500. If you wish, you can have the taxes withheld and sent to the IRS by your plan provider.
Hardship Withdrawal Consequences
Hardship withdrawals are taxable and must be included in your gross income for the year you take out the money. The amount of the withdrawal is limited to the financial need plus the expected taxes that result from it. In addition, you may have to pay a 10 percent penalty tax on the amount withdrawn. Once you make a hardship withdrawal, you cannot return the money to the account. Also, you may not make any contributions to the retirement plan for six months.
The IRS rules that govern hardship withdrawals from employer-provided retirement plans do not apply to traditional or Roth individual retirement accounts. If you must pull money from an IRA, you have to pay any income taxes that result. In addition, you may owe an additional 10 percent penalty tax if you aren’t 59 1/2years old. You don’t get stuck with this penalty if the money you take out is for a purpose the IRS allows as an exception. The IRS says your IRA provider has to withhold 20 percent of the amount you take out.