Despite well-intentioned saving and strategic financial planning, life can throw curveballs that impact your finances. And without cash to fall back on, an unexpected expense could create a challenge. Unfortunately, this is a common situation: 63% of Americans can’t cover a $500 emergency with their savings.
The inability to sustain a financial emergency may explain why more people are taking 401(k) hardship withdrawals. According to the Vanguard Group, which administers 5 million accounts, early withdrawals jumped from 2.8% in 2022 to a record high of 3.6% in 2023.
While a 401(k) hardship withdrawal may seem like a good short-term solution, it can cost you more in the long run. Here’s what you need to know.
What Is a 401(k) Hardship Withdrawal?
A hardship withdrawal is a one-time fixed distribution from your retirement plan in the exact amount of qualifying need.
You typically can’t access your 401(k) or 403(b) without penalty until you reach 59½. Accessing the funds earlier means you could face a 10% penalty on the amount withdrawn and your standard tax rate. However, you may be eligible for an early distribution or a hardship withdrawal if you face an “immediate and heavy financial need,” such as:
- Medical expenses
- Principal residence purchase
- Foreclosure or eviction prevention
- Educational expenses
- Certain repairs to your principal residence
- Funeral expenses
- Disaster-related expenses
A hardship distribution doesn’t give you a free pass to access your savings whenever you want. It should be considered a next-to-last solution for an imminent problem.
How Much Can You Withdraw through a Hardship Distribution?
The amount of money you can withdraw from your 401(k) via a hardship distribution is limited to the immediate need.
Are 401(k) Hardship Withdrawals Charged the 10% Penalty?
A hardship distribution is considered an authorized withdrawal. As a result, the IRS waives the 10% penalty for accessing funds before 59½.
Are Hardship Withdrawals Taxable?
Yes, hardship withdrawals are taxable. You must pay income tax on any previously untaxed money you receive as a hardship distribution.
How Do You Prove the Hardship?
Whether you must provide documentation to prove your hardship depends on your employer’s retirement plan rules. Many plans approve hardship withdrawals through a self-certification process where you provide a written statement confirming:
- Your distribution meets the plan requirements and is for one of the approved “immediate and heavy financial needs.”
- The requested withdrawal doesn’t exceed the amount required to meet the financial needs requirements.
- You have no other reasonable means to satisfy the need.
However, if the employer knows you can access another source of funds, it may deny your request. Other times, the employer may verify your hardship and the necessity of the withdrawal through specific documentation, such as:
- Foreclosure notices
- Funeral home invoices
- University bills
- Hospital or insurance statements
How Long Do Hardship Withdrawal Requests Take?
The hardship distribution process typically takes one to two weeks, depending on the size of your organization and other factors. If your provider has additional questions, the plan administrator may need extra time to review your hardship request.
You should receive a notification when the request is approved and a final notice at disbursement. If you receive the funds via mail, it may take an additional seven to 10 business days after approval; direct deposit or ACH can take two to three days.
What Are the Potential Consequences of a Hardship Withdrawal?
A hardship distribution may be the only path forward if you have no other option. However, understand the potential consequences.
Reduce Your Retirement Savings
Withdrawing money reduces your 401(k) or 403(b) balance, which can affect your future financial stability. You also can’t replace the money you remove from your account.
Increase Your Adjusted Gross Income (AGI)
A hardship distribution is counted as income, which may increase your annual AGI and tax rate.
Lessen the Power of Compounding
The amount you withdraw from your retirement plan no longer benefits from the power of compound interest.
An Example of the Long-Term Costs of Hardship Distributions
Taking a 401(k) hardship withdrawal can have long-term effects. For instance, suppose a 40-year-old woman earns about $120,000 annually. Due to unforeseen events, she takes a hardship distribution of $15,000 to cover a medical bill.
Even though she withdrew $15,000 in gross proceeds, she only netted $11,400 because of her 24% tax rate. The withdrawal can also have a larger impact when she prepares to retire in 25 years. Because the $15,000 wasn’t in the 401(k), it couldn’t compound and earn interest over time, which creates a massive shortfall—she could miss out on tens of thousands of dollars in retirement savings.
Questions to Ask before Taking a Hardship Distribution
Before you take a hardship distribution from your 401(k) or 403(b), understand the implications and explore all potential alternatives. A hardship distribution should be your last course of action. Here are some essential questions to ask yourself:
Does Your Employer Allow Hardship Withdrawals?
Hardship distributions are common, but employers aren’t required to offer them. Verify your plan allows hardship withdrawals and learn the specifics of the process.
Does Your Hardship Qualify for a Hardship Distribution?
Speak to your employer to learn if your situation qualifies for a hardship distribution because all plans differ.
Would a 401(k) Loan Be Better than a 401(k) Hardship Distribution?
A 401(k) loan may be a better option, depending on your situation, so consider both. Unlike a hardship withdrawal, you must repay the 401(k) loan and a reasonable interest rate to your retirement account balance. The interest and repayment help reduce the negative impact on your long-term savings.
Can You Arrange a Payment Plan?
If you need a 401(k) distribution for a medical bill, ask your provider about setting up a payment plan or arrangement. Most healthcare organizations are willing to offer more flexible payment arrangements. A payment plan may also be an option if you need the funds for rent or a mortgage.
How Soon Do You Need the Funds?
A hardship distribution can take anywhere from one to two weeks, so it may not be a viable option if you need the funds immediately. Make sure the time frame works for your needs.
Planning for the Unexpected
No matter your age, having emergency savings is critical. An emergency savings account is a cash reserve for financial emergencies and unexpected expenses. The rule of thumb is to have at least three to six months’ worth of expenses in an account you can quickly access. That way, you can better protect your retirement savings and financial future from the uncertainties of today. Even if you don’t have savings, options like a home equity line of credit or a credit card may be more financially beneficial than a 401(k) or 403(b) hardship withdrawal.
For help reviewing your financial situation and weighing your needs, reach out to a financial professional. A Bankers Life representative can provide personalized insights and guidance to support your financial journey.
Insurers and their representatives are not permitted by law to offer tax or legal advice. The general and educational information here supports the sales, marketing or service of insurance policies. Based upon individuals’ particular circumstances and objectives, they should seek specific advice from their own qualified and duly-licensed independent tax or legal advisors.
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