Let’s assume, for the moment, that you have developed good habits in your financial life. You pay your bills on time every month, you avoid credit card debt, and you save for retirement by maxing out your contributions to your company’s 401(k) plan. You’re living within your means but you’re not rich.
Then, bam! You get hit with a big, unexpected expense and you don’t have enough in savings to cover it.
How are you going to pay for this (without borrowing from relatives)? Hmm… what about the money you’ve been investing into your 401(k) — it’s your money, isn’t it?
401(k) Money Is Supposed to Stay Put
As you probably know, the money invested in a 401(k) plan (or in a 403(b) or 457(b) plan) is supposed to stay there. It is allowed to grow tax-free until you are 70½, which is a hefty incentive to save money in a 401(k) versus a regular investment account.
Since you pay no taxes on 401(k) investment earnings until you withdraw the money, which may be decades from now, 100% of the earnings generated in the account are reinvested year after year. By the time you reach retirement age, this could produce an additional $200K or more versus a non-tax-deferred account, depending on your age when you started contributing (start in your 20s for the biggest gains over your working life), how consistently you make contributions (every year, right?), how much you contribute (go for the maximum) and the return your 401(k) investments earn.
The rules governing 401(k) plans were written this way to motivate us to save for retirement. Since Social Security payments are unlikely to cover 100% of our living expenses after we retire, 401(k) plans are designed to help us put away money and leave it untouched for many years. We’re not supposed to think of that money as an emergency fund.
But what if something happens in your life and you really need money now, not years from now? Can you take money from your 401(k) account?
The answer: maybe.
The Rules for Hardship Distributions
The IRS does allow 401(k) plans to offer a “hardship distribution” option, but not all plans choose to make this available. If you are facing a major, immediate financial hardship, the first thing to do is to ask your HR department whether or not your plan allows for hardship distributions.
If your plan allows for this, you then have to figure out whether your particular hardship qualifies under IRS rules and your plan’s policies. Only certain types of expenses are permitted by the IRS, and each company chooses which ones its particular 401(k) plan will allow.
Here is a list of what may allow you to qualify for a financial hardship distribution from your 401(k):
- Medical expenses that exceed 7.5% of adjusted gross income
- Costs related to buying your principal residence
- Educational expenses
- Preventing a foreclosure or eviction from your principal residence
- Burial and funeral expenses
- Repairs to your principal residence.
“Great,” you may be thinking. “If my spouse loses his/her job and it’s a stretch to make the mortgage payment on our house, I can take a hardship distribution from my 401(k) and we won’t have to sell our getaway cabin in the mountains.”
Not so fast. If you or your spouse have other financial resources, such as a second home or some stock your grandfather left you that you don’t want to sell for sentimental reasons, you would not qualify for a hardship distribution.
Considerations for Taking a Hardship Distribution
Even if you do qualify, a separate question is, should you do this? Should you use your 401(k) money to cover the hardship expense or look for an alternative, such as a loan?
Here are some things to consider:
- Taxes — Hardship distributions are included in your gross income, so you end up paying taxes on that money.
- Penalties — If you are under 59½, you also pay a 10% penalty, and you cannot withdraw more than you need to meet the expense. For example, if you have a $10,000 expense, you cannot withdraw $11,000 to pay for the expense plus the 10% penalty. Note that there are a few situations where you can avoid the penalty, such as becoming totally disabled or satisfying a court order to give the money to your divorced spouse, a child or a dependent.
- Limits — You cannot withdraw more money than you personally contributed. You cannot withdraw the earnings on your contributions or any of the money your employer contributed.
- Future Contributions — After taking a hardship distribution, you cannot make any new 401(k) contributions for six months — you are “locked out.”
- Perhaps most importantly: This is not a loan — You cannot repay a hardship distribution; it permanently reduces the amount of money in your 401(k).
Should You Take a Hardship Distribution?
Let’s say you are suddenly faced with unexpected funeral expenses or suffer damage to your home that is not covered by your homeowner’s insurance. Let’s also assume you are certain you will have additional funds coming in from another source in a couple of months, perhaps from selling an asset you inherited or from a sales commission on a big deal you’ve been working on that is going to happen but won’t close for another 60 days.
Taking a hardship distribution might be allowable, but it would permanently reduce the amount in your 401(k). By using 401(k) money to meet a temporary hardship, you lose the tax-deferred returns you would have earned on that money for perhaps another 10 or 20 years. An alternative may be taking a loan from your 401(k) , which you do repay, with interest.
Life throws curve balls at us, and sometimes that involves an unavoidable financial hurdle. Your 401(k) plan may be a source of money that allows you to overcome that obstacle, but do think long and hard about whether you can find another way to raise the money before taking a hardship distribution. And make sure you consult with a financial or tax advisor before proceeding.