In some cases, you can make a hardship withdrawal from your 401(k) plan to cover what the IRS calls an “immediate and heavy financial need.” While it can provide short-term financial relief, that same withdrawal can create financial challenges in the future.
It can also increase your short-term costs due to taxes and the 10% penalty fee if you are under 59 ½ years old.
What is a hardship withdrawal?
A hardship withdrawal is money taken out of an employer-sponsored retirement plan to address an “immediate and heavy financial need.” Only some IRS safe-harbor expenses qualify as hardship withdrawals, but you will still incur a 10% penalty fee in most circumstances (there are exceptions).
If you take out this type of distribution, it cannot exceed the amount needed to address the hardship. You can’t take any funds meant for a hardship and apply it to a discretionary purchase.
People who are over 59 ½ years old can withdraw funds from their 401(k) plans without worrying about any penalty fees or restrictions, but that’s not the case for people who are younger. Either way, you will have to pay taxes on the withdrawal if it is from a traditional 401(k) plan.
This is different from a 401(k) loan since the hardship withdrawal is out of your account permanently. You cannot replenish it. A 401(k) loan lets you borrow against your account, so you don’t actually have to withdraw any money.
A retirement gap that compounds over time
Although penalty fees and taxes show up right away, there is another expense that comes with hardship withdrawals. Taking out money from your retirement plan weakens its compounding potential.
For instance, if you withdraw $10,000 for an emergency expense, you can miss out on substantial returns if your portfolio can maintain an 8% annualized return over the next 10, 20 or 30 years. It becomes more consequential for workers with low projected Social Security benefits who will rely heavily on their portfolios during retirement.
Annual contribution limits limit how much you can put back into the plan, meaning you may not be able to contribute the same amount you’ve withdrawn immediately. That’s a big risk associated with hardship withdrawals that people may not see right away.
What to consider before withdrawing
You can still take preventive measures like requesting a payment plan instead of a lump sum payment for your emergency expense. A 401(k) loan avoids the permanent loss of funds from your 401(k) plan and can help you avoid penalty fees and taxes — but keep in mind that the entire 401(k) loan balance may become due if you leave your current job.
In some cases, a hardship withdrawal may be your only option. If that’s the case, restart contributions promptly and contribute at least enough to receive the employer match once you address the hardship. Building an emergency savings account is critical as well. Vanguard found that having $2,000 in an emergency fund can reduce the likelihood of financial distress and enhance overall well-being.
