What Is a Hardship Withdrawal?
A hardship withdrawal, as defined by the Internal Revenue Service (IRS), is an urgent withdrawal of retirement plan funds due to an immediate and significant financial need. This special distribution can be made from accounts like a traditional individual retirement account (IRA) or a 401(k), subject to specific criteria regarding the necessity and amount of the funds. While this withdrawal may be exempt from the IRS penalty of 10% for early distributions before age 59½, standard income tax will still apply, unless it involves a Roth account.
However, despite potential penalty waivers, the IRS and most employers that offer 401(k)s impose strict guidelines on hardship withdrawals to regulate their usage and amount. The regulations governing these withdrawals and their administration vary based on the type of retirement fund.
**Key Takeaways**
- If you’re under 59½ and facing financial hardship, you may be eligible to withdraw funds from your retirement accounts without the usual 10% penalty.
- Not all financial hardships qualify, and income tax payment on the withdrawal is mandatory unless it’s a Roth account.
- Remember that there is no option to return the withdrawn funds to the account if your financial situation improves.
- Explore alternatives like a Substantially Equal Periodic Payments (SEPP) plan before opting for a hardship withdrawal.
Hardship Withdrawals From IRAs
Early withdrawals from an IRA, before age 59½, may exempt you from the 10% penalty in specific situations, such as buying a first home or pursuing higher education.
Unlike a loan from a 401(k), funds withdrawn through a hardship withdrawal cannot be repaid to the account, irrespective of any financial improvements.
Hardship Withdrawals From 401(k)s
The eligibility and reasons for taking a hardship distribution from a 401(k) or 403(b) plan are determined by the sponsoring employer. The IRS clarifies that offering hardship distributions is at the discretion of the retirement plan, with specified criteria like medical or funeral expenses to define hardships. Employers may request documentation to support the hardship claim.
If approved by the employer for a particular need, IRS rules decide whether the 10% early withdrawal penalty is waived for those under 59½ and the withdrawal limit. While the conditions are similar to IRA waivers, there are some distinctions.
Hardship Withdrawal Alternatives
For individuals under 59½ contemplating a retirement account withdrawal, an alternative without the 10% penalty is the SEPP plan. Under this plan, funds earmarked for withdrawal are placed in the SEPP program, which then disperses annual distributions for at least five years or until the account holder reaches 59½, with income tax still applicable on the early withdrawals.
Note that commitment to a SEPP plan should be long-term, as discontinuing before the minimum period triggers repayment of waived penalties to the IRS. Moreover, SEPP participation with an employer-sponsored plan, like a 401(k), mandates a cessation of employment with the sponsoring employer. Any changes to the account balance during the SEPP program can lead to disqualification and the reinstatement of penalties.
Despite these restrictions, a SEPP plan can be a viable solution for early fund access, offering flexibility in expenditure compared to hardship withdrawals.
What Qualifies as a Hardship With the IRS?
IRS-recognized hardships include using IRA funds for education or a first-home purchase and multiple hardship options for 401(k) holders, covering medical and funeral costs.
Why Would a Hardship Withdrawal Be Denied?
A hardship withdrawal may be declined if the plan does not allow for withdrawals under that particular circumstance. Withdrawal policies vary among retirement plans.
Can You Do a Hardship Withdrawal to Pay Off Debt?
According to the IRS, using funds to pay off debt does not qualify for a hardship withdrawal.
The Bottom Line
While hardship withdrawals offer immediate financial relief without a credit evaluation, they should be a final resort after exhausting all other options. These withdrawals may incur income tax, potentially increasing your tax liability for the year, and permanently reducing retirement savings.
Due to the implications, consider hardship withdrawals only for urgent and exceptional needs.