Should You Take a 401(k) Hardship Withdrawal Now?

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If you need money badly and your 401(k) balance beckons, what’s the best strategy?

Under most 401(k) plan rules, you can take a “hardship withdrawal” from your plan under certain circumstances, because of an “immediate and heavy financial need,” according to the IRS. These are the kinds of expenses that qualify:

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— Generally, expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care;

— Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);

— Payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, or the employee’s spouse, children, or dependents;

— Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;

— Burial or funeral expenses for the employee’s deceased parent, spouse, children, or dependents; or

— Certain expenses relating to the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under IRC 165.

While a hardship withdrawal sounds like a panacea under these conditions, it’s hardly ideal. You would face a tax hit.

“Remember that when you’ve been approved for a withdrawal, you’re not off of the IRS radar screen,” notes the 401khelpcenter. “A hardship withdrawal is a taxable event, so you will have a mandatory 20 percent withholding tax taken out of the check. You may end up owing more, depending on your total income for the year. You may also be subject to the 10 percent penalty if you are under age 55.”

Is the tax hit worth it? Let’s do some math.

“The tax burden on early withdrawal hits you in two different ways,” the 401khelpcenter continues. “First, your withdrawal is subject to ordinary income tax. For example, if you normally pay 28 percent federal tax and 4 percent state tax, then a $10,000 hardship withdrawal will lose $3,200 to the government.”

“Second, your withdrawal may be subject to a 10 percent early-withdrawal penalty on the full amount. The only reason you wouldn’t pay the penalty is if you are over age 55 or if the IRS grants you an exemption. Even though, in our example, you are paying $3,200 in taxes already, you still pay the 10 percent penalty on the full amount, or a penalty of $1,000.”

“Put these two numbers together and you can see that the $10,000 withdrawal only leaves you with $5,800 after taxes. On average, you’ll pay between 25 percent and 40 percent or more in taxes and penalties from your hardship withdrawal, according to retirement expert Ted Benna.”

Ultimately, what looks like “free money” is actually a costly transaction that will take money out of your retirement kitty.

If you need to save money for college, consider 529 Savings Plans, For health expenses, a Health Savings Account is a much better vehicle. At the very least, though, an emergency savings account is always a good place to start. That way you avoid the nasty tax consequences of tapping into your retirement fund.


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