Sometimes, life doesn’t go according to plan. You may have damages to your home, large medical bills, or other financial hardships that require extra cash. One solution to getting access to fast-cash is to take a hardship distribution from your 401(k) or another employer-sponsored retirement plan. However, there’s a lot to consider before you take out money from your retirement plan. So, here are a few things you should consider before taking a hardship distribution.
What is a hardship distribution?
A hardship distribution is a withdrawal from your employer-sponsored retirement account such as your 401(k). This distribution is due to a qualifying immediate financial need. Typically, you can’t withdraw from a retirement account until you reach age 59 ½. However, a hardship distribution allows you to take money out of your plan when you have a financial need and can’t obtain the necessary funds elsewhere. All distributions are limited to the amount necessary to satisfy the financial need.
Also, usually, when you take an early distribution from your 401(k) you may have to pay a 10% penalty and income taxes. If you qualify for a hardship distribution, the penalty might be waved depending on the type of expense. However, either way, you will have to pay income taxes on the full amount.
To qualify, you must meet the following criteria:
- The distribution is only for your immediate financial need. This includes the amount necessary to pay any taxes resulting from the distribution.
- The employee has received any other available distributions. This may include the employee stock option dividends and any non-taxable plan loans. It also includes any other available distributions from the employer.
- The employee may not make any elective deferrals to the plan for at least six months after receiving their hardship distribution.
Why you might need to take a hardship distribution
Now that you know what a hardship distribution is, you may be wondering what type of expenses qualifies.
In short, a hardship distribution is used to cover a specific cost. These costs might include a funeral cost, medical expenses, tuition or educational fees. The costs may also include payments necessary to avoid eviction or foreclosure on a principal residence.
Safe Harbor Distributions determine what qualifies as an immediate and heavy financial need. If an employee is unable to cover certain expenses, they may qualify for a hardship distribution. Some of the qualifying expenses may include:
- Certain medical care expenses for the employee, their spouse, or their dependents
- Costs related to their home excluding a mortgage payment
- Tuition, room, board, and fees for the employee, their spouse, or their dependents
- Payments necessary to protect the employee’s eviction from or foreclosure on their primary residence
- Funeral expenses for the employee, their spouse, or their dependents
- Expenses necessary to repair damage to the employee’s primary residence
Some costs that a hardship distribution may not cover include purchases of items such as electronics or properties, frivolous purchases, or even mortgage payments. Typically, elective costs aren’t eligible for this type of distribution.
Recently, the passing of the CARES Act has expanded distribution eligibility. If you have a financial need due to the coronavirus, you can take a coronavirus-related distribution. These special distributions have specific stipulations which include:
- A $100,000 or account balance limit (whichever is smaller)
- Your ability to spread out any taxes due over three years
- An option to pay the distribution back within three years and not be subject to any taxes since it’s considered a roll over
Consequences and tax implications
While a hardship withdrawal might keep you financially afloat in the short-term, it can come with significant penalties. Again, hardship withdrawals are taxable income and are also subject to an additional 10% tax on the amount withdrawn. This, of course, will depend on the type of expense you’re using your distribution for. However, this is only the short-term cost.
When you consider long-term costs, you must think about the lasting impact on your retirement account. When you save for retirement, compounding interest helps to maximize your savings. If you decrease the balance of your retirement account, you impede your ability to earn interest over time. Depending on your savings, retirement plan, and amount of your financial hardship, taking a hardship distribution may delay your retirement date.
Additionally, when you take a hardship distribution, many plans will not allow you to contribute to your retirement account for the following six months. Therefore, you are not only decreasing your account balance but your ability to contribute to it. This will also affect your long-term savings goals.
When you should avoid a hardship distribution?
Due to the nature of a hardship distribution and its associated taxes and potential penalties, you should almost always avoid taking a hardship distribution. However, sometimes it’s your only option. Before you take a hardship distribution, you should take the time to review the terms of your retirement plan. This may mean calling your plan’s provider, as well as speaking with your financial planner.
Then, you can evaluate your hardship and determine if it qualifies as hardship distribution in your employer’s plan. If you determine it qualifies, you must provide documentation proving you exhausted all other options. Finally, ensure that the amount of your hardship is available in your retirement fund before making a hardship withdrawal.
The bottom line
Hardship withdrawals carry hefty fees as well as long-term implications. Taking a hardship withdrawal can be expensive upfront and even cause you to delay your retirement. You may only want to use them when you have exhausted all other options. If you believe that a hardship withdrawal is the best option for you, you should still speak with a financial planner before making this withdrawal.
A financial planner will help you to look at the big picture and minimize the long-term effects of making a hardship withdrawal. Schedule a meeting with a financial planner with The Retirement Solution today.