401(k) Hardship Withdrawals Explained (and alternative options)

From Everything Finance

401(k) Hardship Withdrawals Explained (and alternative options) is a post originally published on: Everything Finance – Everything Finance – Its all about Money!

When you need money for an emergency, you might turn to money in your 401(k) retirement plan. While you typically can’t access money from your 401(k) until you reach age 59 ½ or leave employment, the IRS allows hardship withdrawals for “immediate and heavy” financial needs in certain circumstances.

Withdrawing funds from a 401(k) is often a last resort because you may have to pay income taxes on the amount, plus a 10% penalty. Still, it’s worth understanding how 401(k) hardship withdrawals work and how they compare to common alternatives. 

What Is a 401(k) Hardship Withdrawal?

A 401(k) hardship withdrawal, also called a hardship distribution, is a type of early withdrawal from your 401(k) meaning a withdrawal you make before you turn 59 1/2. There are special circumstances when you can make hardship withdrawals from your 401(k) account. These include paying for medical care, covering funeral expenses for your spouse or child, or even purchasing a home.

A 401(k) hardship withdrawal can provide you with cash when you’re in a bind. Just keep in mind that you still owe income taxes on any distribution and if you withdraw money from your 401(k) before age 59 ½, the IRS may charge a 10% early distribution penalty on the amount you take out.

Who is Eligible to Take a Hardship Withdrawal?

To be eligible for a hardship withdrawal, you must have an immediate and heavy financial need that cannot be fulfilled by any other reasonably available assets. This includes other liquid investments, savings, and other distributions you are eligible to take from your 401(k) plan.

Possible Reasons for a 401(k) Hardship Withdrawal 

The IRS lists seven situations that may qualify for 401(k) hardship withdrawals: 

• Non-mortgage payment costs when you’re buying a home that you’ll use as your principal residence
• Certain expenses to repair your principal residence
• Payments to avoid eviction from or foreclosure on your principal residence 
• Medical expenses 
• Higher education expenses for the next 12 months of postsecondary education
• Funeral expenses 
• Expenses or losses related to a federal disaster declaration if your primary residence or job is in the disaster zone 

RELATED: 6 Ways to Diversify Your Retirement Income

Hardship Withdrawal Limits

At a maximum, you can only withdraw enough to cover the cost of the immediate and heavy need, plus the taxes and penalties on the amount. The minimum amount you can request is $1,000. If your vested account balance is less than $1,000 you will not be able request a hardship distribution.

You also might be limited by how much you have in your 401(k). Depending on your plan, you might only be able to withdraw money that you contributed—but not your earnings. But some plans might also let you withdraw money that your employer contributed, such as 401(k) matching contributions. 

Alternatives to a 401(k) Hardship Withdrawal

While a 401(k) hardship withdrawal can be helpful if you’re facing a crisis, it should only be used as a last resort. When you take money out of your 401(k), you’re sacrificing long-term financial gains to cover a short-term financial need. If possible, exhaust other options before considering a hardship withdrawal, options such as:

401(k) Loan

A 401(k) loan allows you to borrow $50,000 or half the vested amount from your retirement plan, whichever amount is less. You repay the loan with interest, typically over a five-year term.

A 401(k) loan has no effect on your credit rating. 401(k) loans aren’t immediately taxable unless you leave your job. If you leave the company before the term is up, you have to repay the full outstanding balance or it’s counted as an early distribution, and subject to income taxes and penalties.

Roth IRA Withdrawal

A Roth individual retirement account (IRA) can be an invaluable resource if you’re facing emergency expenses. Since contributions to a Roth IRA are made with after-tax dollars, you can withdraw money without paying taxes or penalties.

Cash-Value Life Insurance Loan

Life insurance loans are only available on permanent life insurance policies such as whole and universal life that have a cash value component. But borrowing against a life insurance policy isn’t risk-free; unpaid life insurance loans may reduce your death benefit or cost you your policy.

Personal Loan

Before withdrawing money from your retirement account, consider taking out a personal loan. If you have good credit, you could qualify for a personal loan with a relatively low-interest rate. Some personal loan lenders have rates as low as 5.4%.

The loans are unsecured, so you don’t have to worry about collateral, and you can repay your loan over several years.

Low-Interest Credit Card

For individuals with very good credit, a credit card with a 0% APR offer could be a useful alternative to 401(k) hardship withdrawals. Cards with promotional offers usually charge 0% APR for the duration of the introductory period, often six to 18 months in duration. After that, the regular APR applies.

A low-interest credit card can give you time to pay off the emergency expense without interest accruing, and you wouldn’t have to drain your retirement fund. However, make sure you pay off your balance in full by the end of the promotional period; otherwise, hefty interest charges will apply.

RELATED: Should I use a Personal Loan to Pay off Credit Card Debt

Bottom Line

Facing an emergency can leave you with limited choices. In most instances, 401(k) hardship withdrawals should be considered a last resort for obtaining funds. The taxes and penalties associated with hardship withdrawals and the impact such withdrawals may have on your retirement finances can make them an expensive source of funds. 

But If you’re faced with an emergency, consider all of the borrowing options mentioned above before you tap into your 401(k).

401(k) Hardship Withdrawals Explained (and alternative options) is a post originally published on: Everything Finance – Everything Finance – Its all about Money!

This post was published on Everything Finance