One day you’re enjoying your job and loving life. Things are going well and you have no complaints. Then, seemingly overnight, you’re living your worst nightmare. You’ve been laid off, your unemployment benefits will end soon, and you’ve blown through your emergency savings fund. If you’re in a tight spot and you can’t figure out how to make ends meet, you might be considering requesting a hardship withdrawal from your retirement account. This is often the last resort for those who have cleaned out their savings and run out of other sources of money.
Ed Snyder, a certified financial planner and co-founder of Oaktree Financial Advisors, says that while a hardship withdrawal can be a lifesaver in a time of need, there are still some catches to watch out for. “A 401(k) hardship withdrawal helps bail you out of a really tight spot when you have no other options. However, depending on your income and the amount of the withdrawal, the distribution could put you into a higher tax bracket,” warns Snyder in an interview with The Cheat Sheet.
Here’s what you should know before you withdraw money from your retirement account.
1. Your request could be declined
Not all retirement plans offer the option for hardship withdrawals because it’s not a required feature. So make sure to check first and see if you are able to receive a distribution. Also know that a determination will be made regarding whether you really have a significant need. If it is determined that you or your spouse have assets available, you will most likely not be granted a hardship distribution. The IRS uses a vacation home as an example of an available asset that could be liquidated to help cover an unexpected financial emergency.
2. Know what qualifies as hardship
If your retirement plan does offer the option to take a hardship withdrawal, it will outline the specific requirements to qualify. One of the requirements is that you must have what is referred to by the IRS as an “immediate and heavy financial need.” The IRS automatically considers an employee to be in immediate and heavy financial need if the distribution request is for expenses such as funeral costs or significant medical costs. You’ll also automatically qualify if you need the money to prevent an eviction from or foreclosure on your primary residence. These are known as safe harbor distributions. For further information on what qualifies as a safe harbor distribution, see the IRS publication titled Retirement Topics—Safe Harbor Distributions.
When it comes to 401(k) hardship withdrawals, your family won’t be left out in the cold. Requests can also be made to meet the financial need of a spouse or dependent. In addition, a request can also be made for expenses to assist a non-spouse or non-dependent beneficiary, thanks to the Pension Protection Act of 2006.
3. You’ll have to wait to make future contributions
If you’re suddenly in the position to contribute to your plan again, tough luck. Know that if you want to make contributions to the plan, you’ll generally be required to wait at least six months after you receive a hardship distribution. That means you lose the value of having your money invested in the markets.
4. You’ll owe taxes–and most likely penalties, too
Taxes and penalties are in your future. Unlike a 401(k) loan, a hardship distribution does not have to be repaid. However, you will owe taxes on the distribution because it’s considered income. In addition, if you are less than age 59 ½, you’ll also owe a 10% early withdrawal fee.
Jeff Rose, certified financial planner and founder of personal finance blog Good Financial Cents, says a 401(k) hardship withdrawal should be taken with caution. Depending on the situation, the consequences could outweigh the benefits. He recommends looking at other options first, such as taking out a personal loan. “Using a 401(k) hardship withdrawal should only be done as a last resort. Look for all other options for accessing money before tapping into your 401(k) retirement savings,” Rose says on his blog. “A 401(k) hardship withdrawal reduces the amount of your retirement account permanently since it’s never repaid, you’ll miss out on compounding interest and earnings, and most likely pay both income taxes and penalties on the amount withdrawn, making it an expensive option for gaining access to your money.”