Emergencies happen, and that’s why it’s a good thing that
retirement accounts such as a 401(k) or an IRA allow you to take hardship or
early withdrawals from your account. In tough financial straits it makes little
sense to have an account with cash but be completely unable to tap into it.
Here’s how hardship withdrawals work and some ways to avoid
penalties for using them.
What is a hardship withdrawal?
A hardship withdrawal allows the owner of a 401(k) plan or a
similar retirement plan (such as a 403(b)) to withdraw money from the account
to meet a dire financial need.
Hardship withdrawals are treated as taxable income and may
be subject to an additional 10 percent tax. So the hardship alone won’t let you
avoid those taxes. However, you may be able to sidestep the 10 percent penalty
tax in some situations, as discussed below.
The IRS is clear as to what counts as a hardship: The event
must pose “an immediate and heavy financial need of the employee.” The agency
lays out some guidelines that qualify:
Certain medical expenses
Costs relating to the purchase of a principal residence
Tuition and related educational expenses
Payments necessary to prevent eviction from, or foreclosure
on, a principal residence
Burial or funeral expenses
Certain expenses for the repair of damage to the employee’s
residence
“Expenses for the purchase of a boat or television would
generally not qualify for a hardship distribution,” says the IRS. “A financial
need may be immediate and heavy even if it was reasonably foreseeable or
voluntarily incurred by the employee.”
The IRS demands that the 401(k) withdrawal is the last
resort. If an individual has other assets to meet the need (including those of
a spouse or minor child), those resources must be used first. And that includes
non-cash assets such as a residence that could be mortgaged for cash.
IRAs
As for IRAs, the IRS says that there’s generally not
hardship distributions from an IRA. That’s because you can take whatever money
you need from the account when you need it – though you may end up paying taxes
and penalties, depending on the specific circumstances.
However, these IRA distributions may take advantage of
similar hardship “loopholes” as 401(k) plans and avoid additional taxes on
early distributions (but not typical taxes on distributions).
For example, an IRA owner can avoid the 10 percent bonus
penalty in the following scenarios:
Higher education expenses
Qualified first-time homebuyers, up to $10,000
Unreimbursed medical expenses greater than 10 percent of
adjusted gross income
Health insurance premiums while unemployed
While the IRS permits hardship withdrawals and other early
distributions, you’ll want to consider whether you truly do need one. You’ll
also want to consider how best to tap your accounts so that you minimize any
hit to your retirement funds.
5 ways to avoid penalties on a hardship withdrawal
It’s important to emphasize that generally you cannot avoid
all taxes on your withdrawals, even hardship withdrawals, with the notable
exception of those from a Roth IRA. But you may be able to sidestep the penalty
tax by tapping the right account or accessing your cash in the right way.
1. Pay attention to which hardships qualify
While the IRS may allow certain kinds of expenses to qualify
for a hardship withdrawal, that doesn’t mean the employer’s 401(k) must also
allow them. For example, medical and funeral expenses may be included in your
employer’s plan, but not expenses for a principal residence.
You’ll need to check with your employer to see what’s
permitted under its 401(k) plan.
For IRAs, however, the withdrawal guidelines are uniform. So
you can make early withdrawals that meet the IRS criteria and avoid that 10
percent bonus levy on your gains.
2. Stay within the limits
Hardship withdrawals must stay within the limits of the
actual financial hardship, however that’s defined by the plan. For example, a
401(k) hardship withdrawal is limited to the immediate financial need. So you
cannot take out more than you need in any one hardship scenario.
Your 401(k) plan may limit your hardship withdrawal to your
own contributions, as well. So you’ll want to carefully check how much you are
able to access and stay within the rules.
In the case of IRAs, you can avoid a 10 percent penalty on
IRA withdrawals related to medical hardship, among other reasons. But the
hardship amount must be the difference between the actual need and 10 percent
of your adjusted gross income. So you’re footing the bill for that first 10
percent and only then may you receive a penalty-free withdrawal on the
subsequent amount.
In either case, abide by the plan’s rules carefully.
3. Pick the ‘right’ 401(k) withdrawal reasons
While the IRS may allow you to make a hardship withdrawal,
that doesn’t mean you’ll escape the 10 percent penalty tax (again, on top of
what you’ll already pay in taxes on the distribution).
Only certain kinds of early withdrawals escape the penalty
tax, including the following:
Separation from service after age 55
Medical expenses above 10 percent of adjusted gross income
Permanent disability of the account owner
A series of substantial equal periodic payments from the
account
So if they need the money for other hardship reasons (such
as a principal residence, tuition or funeral expenses), account owners will
still end up paying the 10 percent penalty tax.
4. Focus on your Roth IRA first
Instead of a 401(k) hardship withdrawal, tap your Roth IRA
first. Accessing a Roth IRA provides an advantage over a hardship withdrawal,
and you won’t even need to prove hardship to do so.
A Roth IRA allows you to take out your contributions at any
time without any taxes. Since those contributions were made with after-tax
funds, you’ll get to skip all taxes when they come out of the account. This
special treatment doesn’t apply to the earnings on the account, however, which
will incur further taxes and penalties, if required.
Of course, you can also access your traditional IRA at any
time, though you may not be able to avoid taxes while doing so.
5. Try a 401(k) loan
While you may be enduring tough times, that doesn’t mean
you’re limited to only a hardship withdrawal. As an alternative, consider a
401(k) loan, which can offer some advantages.
With a 401(k) loan, you can take out the money you need,
while avoiding taxes and penalties associated with a hardship withdrawal. In
addition, you’ll be able to pay back the loan, meaning you can ultimately enjoy
the benefits of the retirement account’s tax advantages. That is, the repaid
money may be able to continue growing under the account’s tax-advantaged
umbrella.
In contrast, a 401(k) may disallow your contributions for
six months after a hardship withdrawal, and you will not be allowed to replace
the money, hurting your retirement security further.
However, some may see the need to repay the loan not as an
advantage, but as a negative. In any case, you’ll need to repay the 401(k) loan
as you would with a typical loan.
One caveat: If you leave your employer for some reason,
you’ll be forced to repay the loan by the filing date of your federal taxes for
the year in which it happened. Otherwise, it’s considered an early withdrawal
and you’ll be stuck with regular taxes as well as penalty taxes.
Bottom line
Experts strongly advise that you avoid any kind of
withdrawal from your retirement accounts, because it severely disrupts your
long-term financial security.
“Taking a hardship distribution will have adverse tax
consequences that participants should consider prior to taking,” says John C.
Hughes, an ERISA/benefits attorney with Hawley Troxell in Boise, Idaho.
“Additionally, it diminishes the amount of money that will be available upon
retirement, which of course is the purpose of the retirement plan.”
Nevertheless, if you do need a hardship withdrawal, follow
the retirement account’s rules scrupulously and minimize any taxes and
penalties that you do have to pay.
Click here for the
original article.