A 401(k) is a great place to put away pre-tax dollars and save up for retirement. Normally, you can't touch that money without paying a penalty until you reach a certain age; for example, if you're only 40 years old and you drain your 401(k) using a regular withdrawal, you will have to pay a penalty on top of the taxes you'll owe. However, the IRS does permit you to access that money without penalty if you obtain a hardship withdrawal, but only under certain circumstances.
Hardship withdrawals from a 401(k) are not subject to a penalty if they are taken because of total and permanent disability or unreimbursed medical expenses up to a certain amount. Hardship withdrawals for any other reason are still subject to a penalty.
How a 401(k) Plan Generally Works
A 401(k) plan is a pre-tax retirement account set up by your employer to help you save for retirement. The benefit of a 401(k) plan is that you can have your employer take a certain amount out of your gross pay every pay period to deposit into the 401(k) account, where it will accrue interest on a tax-deferred basis. You can contribute up to $18,500 of your pre-tax money to your account as of 2018; in the 2019 tax year, the limit will increase to $19,000.
Your employer may also have a matching program in which it contributes even more money, matching your own contributions up to a certain amount.
Because your contributions come out of your check before taxes, you're not paying taxes on your contributions before they're deposited, so the money you add to the account grows tax-free until you start receiving distributions from it after you retire. At that point, you're taxed on the distributions as income.
Penalties for Early 401(k) Withdrawals
Since 401(k) plans are retirement savings accounts and are subject to some generosity from the federal government as far as taxation, you must wait until you reach a certain age before you can withdraw money from the account without penalty. Generally, if you withdraw money from your 401(k) before you reach the age of 59 1/2, you will incur a 10 percent early withdrawal penalty.
Withdrawing From a 401(k) Without Penalty
There are exceptions to the early withdrawal penalty. If you leave your place of employment during the year in which you turn 55 or after you turn 55, you can start your penalty-free withdrawals early. However, if you quit your job before you turn 55, you have to wait until you're 59 1/2 to withdraw without penalty. For example, if you retire at age 60, you can withdraw from your 401(k) without penalty or if you're 57 and you leave your job, you can start withdrawals early. If you're younger, though, you may still be able to withdraw funds without penalty by either taking out a 401(k) loan and repaying the funds with interest or by seeking a hardship withdrawal if your issues are related to medical bills or disability.
What is a 401(k) Hardship Withdrawal?
The IRS permits you to take an early withdrawal from your 401(k) if you can demonstrate an "immediate and heavy financial need." This means your withdrawal must be for the purpose of paying medical bills, paying educational expenses (including tuition), preventing foreclosure or eviction, paying for a funeral or a burial after a death, buying a new residence or making certain repairs to your house. You must also be able to show that you have no other way of paying for these expenses and the hardship withdrawal is your only option. You may be required to take a 401(k) loan first before you can seek a hardship withdrawal.
Not All 401(k) Plans Permit Hardship Withdrawals
The IRS permits hardship withdrawals but does not require them, and the Internal Revenue Code provides a ceiling, not a floor. The IRS determines how withdrawals are penalized and taxed; your individual plan can permit whatever it likes within those parameters.
You'll need to check the details of your 401(k) plan to make sure hardship withdrawals are an option. The plan may permit the withdrawals but limit how much you can take or what you can do with the money. For example, some plans may provide that you can use a hardship withdrawal to pay for educational expenses, but some may not. Some may also provide that you can't contribute again for six months after obtaining a hardship withdrawal.
Some Hardship Withdrawals Won't Incur a Penalty but Some Will
Hardship withdrawals taken because the plan owner is permanently and totally disabled are not subject to the early withdrawal penalty. You will also not incur a penalty for any hardship withdrawal taken to cover unreimbursed medical expenses up to 10 percent of your adjusted gross income if you're under age 65, or up 7.5 percent if you're 65 or over. For example, if you have $100,000 in medical bills and you're under the age of 65, you can take a penalty-free hardship withdrawal to pay them, but only up to $12,000. The remaining $88,000 will be subject to the penalty.
Hardship withdrawals for any other reason, including educational expenses, first-time homebuyers or repairs to your house, are still subject to an early withdrawal penalty.
How Much Can You Take in a Hardship Withdrawal?
Your individual plan will provide limits for how much you can take from your 401(k) via a hardship withdrawal; generally, however, you can only take the amount necessary to pay for the hardship circumstance and any associated taxes and penalties. Further, under the IRS rules, for 2018 and prior, you were capped at whatever amounts you personally had contributed from your pretax paycheck. So if you contributed $10,000 in 2018 and your employer contributed $5,000, you could only take a withdrawal of up to $10,000.
You Can Withdraw More Beginning in 2019
Beginning in 2019, your plan may allow you to withdraw up to your employer's contributions as well, plus your actual earnings on your investments in the account. Your plan may also permit hardship withdrawals without requiring you to take out a loan first. Better still, you will no longer be required to wait six months to start contributing again after you take the hardship withdrawal. Your plan is not required to make these changes, however, so you should continue to check the terms and conditions of your particular plan.
Another Option: The 401(k) Loan
A 401(k) loan is a loan you take from your 401(k) account. Essentially, you're borrowing money from yourself, and you have to pay it back with interest. Because it's a loan, you don't have to explain why you're taking the loan out. There are no "hardship loans" because you can take the money out for any reason or no reason at all. The repayment will be taken from your paycheck every pay period, and it will include interest, which you're paying to yourself.
There is no early withdrawal penalty associated with a 401(k) loan. However, the repayment amounts are taken out after taxes and deposited, and then you will be taxed on those funds again when you begin your retirement distributions.
- FINRA: 401(k) Loans, Hardship Withdrawals and Other Important Considerations
- HARDSHIP | definition in the Cambridge English Dictionary
- IRS: Retirement Plans FAQs Regarding Hardship Distributions
- The Motley Fool: Way Behind on the Bills? A 401(k) Hardship Withdrawal May Be Your Best Bet
- Society for Human Resource Management: Budget Law Eases 401(k) Hardship Withdrawals
- IRS: 401(k) Plan Overview
- IRS: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- IRS: Publication 560 (2017), Retirement Plans for Small Business
- Kiplinger: When You Can Tap a 401(k) Early With No Penalty
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.