401(k) Hardship Withdrawal vs. Borrowing from a 401(k)

401(k) hardship withdrawals

With a traditional 401(k), you can only make penalty-free withdrawals after you reach age 59 ½. We always advise clients to avoid touching their 401(k) funds until retiremen

However, we understand there are certain situations where the need might be financially necessary as a final resort.

The IRS understands this, too. In fact, the IRS acknowledges “hardship distributions.”

The IRS defines hardship as “an immediate and heavy financial need.” The IRS also restricts the distribution to only “the amount necessary to satisfy that financial need.”

The IRS expands on situations that fall under this definition:

• “Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary
• Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
• Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
• Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
• Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
• Certain expenses to repair damage to the employee’s principal residence”

However, these hardship distributions are not without penalty. In addition to your distribution being taxed as ordinary income, you’ll also face a 10% withdrawal penalty. There are exceptions to this 10% penalty, like certain unreimbursed medical expenses.

The IRS adds further restrictions on these types of early distributions, prohibiting employees from making elective contributions to the plan for six months after the hardship withdrawal.

Keep in mind that hardship distributions are optional, and not all 401(k) plans are set up to allow these.

We highly recommend talking to a financial advisor before making early withdrawals from your 401(k), as there may be a better strategy for meeting pressing financial needs.

Borrowing from a 401(k)

A 401(k) loan, on the other hand, allows you to borrow funds from your 401(k). Loans, so long as they are paid back in full and on time, are not considered taxable distributions. Keep in mind that not all plans offer the option for loans.

There are limits to the amount you can borrow, however.

As the IRS explains, “the maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”

This loan is like any other loan, with interest paid on the loan amount. You’ll also be required to pay back the loan within five years of taking it out. Repayments must be made, at minimum, quarterly. The upside, however, is that the interest paid will go straight into your 401(k).

But if you default on the loan? You’ll be subject to income taxes and the 10% early withdrawal penalty for those under the age of 59 ½.

If you leave your current job prior to paying off the loan, you may also be required to pay it back in full in a much shorter time frame.

Before making a decision on a 401(k) loan, we encourage you to discuss all your funding options with a financial advisor.