Patrick Islip, Islip.net, Certified Public Accountants, Sacramento and Auburn California CPA's
401k Hardship Withdrawals
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Written by Patrick Islip, CPA

 

401k Hardship Withdrawals

You find yourself facing a financial hardship and you think of using you 401k.  This leaves you wondering:  Is it possible to take a 401k hardship withdrawal distribution?  Here are some thoughts for you to consider.

401k Retirement Plans

The purpose of 401k plans is to encourage individuals to save for retirement.  Tax laws allow you to fund your plan with pre-tax dollars, and allow that money to grow on a tax-deferred basis until withdrawal.  In exchange for the tax shelter that a 401k plan provides to employees, tax laws restrict the withdrawal of that money before age 59 1/2.

401k Withdrawals

Some 401k plans allow employees to withdraw funds for many reasons.  Typically, these 401k withdrawals are limited to the elective portion of the deferral, and not any income or interest on the deferred amounts nor any company matching funds.  However, these types of plans are more the exception than the rule.  Generally, money can be withdrawn from a 401k account if a financial hardship exists, and only in very limited situations.

Financial Hardship Definition

The exact rules followed by each 401k plan will vary.  But generally, a financial hardship is deemed to exist if a participant in the plan experiences an immediate and heavy financial burden.  In addition, the participant must have no other financial means of meeting this hardship.

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Examples of financial hardships include:

Potential eviction or foreclosure on the participant's principal residence.

The participant needs substantially all of his or her current and anticipated income and assets to meet their current and anticipated ordinary and necessary living expenses.

Demonstrating true financial hardship usually requires more proof than just the repayment of money owed to creditors.  That is, the burden of proof must be greater than merely the inconvenience of repaying a debt.

To discourage the use of 401k plan funds for any reason other than retirement purposes, early withdrawals are subject to a 10% federal penalty and a 2.5% California penalty.  This means any money withdrawn from your 401k account before age 59 1/2 many not only be subject to income taxes based on your incremental tax bracket, but also a 12.5% penalty.

The tax code, however, does allow penalty-free withdrawals if the hardship meets certain criteria.

Criteria for 401k Hardship Withdrawals

There are basically three ways money can be taken from a 401k account without penalty:

  1. The distribution or withdrawal must be made after termination of employment, if you are age 55 or older in that calendar year.

  2. Distributions or withdrawals are made to an alternate payee under a qualified domestic relations order.  This often happens as part of a divorce settlement.

  3. Withdrawals or distributions of dividends from employee stock ownership plans or ESOP.

Safe Harbor Hardship Withdrawals

The IRS also has a provision for employers to provide for a safe harbor withdrawal from a 401k plan if an immediate and heavy financial need or burden exists.  The only money exempt under the safe harbor rule is that which is used to satisfy that immediate and heavy financial need.  According to the IRS, the safe harbor hardship withdrawals from a 401k plan are limited to:

  1. Money used to pay certain medical expenses for you, your spouse, or any of your dependents.
  2. Payments of specific post-secondary education expense for the next year for you, your spouse, or any of your dependents.
  3. The purchase of a primary residence.
  4. Money needed to prevent eviction or foreclosure on your primary residence.

Hardship withdrawals or distributions are includible in gross income for federal and state income tax purposes, unless they consist of Roth contributions. They may be also be subject to a 12.5% additional combined federal and state tax on early distributions.

Your 401k summary plan description (SPD) will state whether or not your employer allows withdrawals in your plan.  If withdrawals are allowed, your employer will provide the forms and explain the process you will need to follow to demonstrate financial need for the withdrawal.

The IRS code that governs 401(k) plans provides for hardship withdrawals only if:

  1. Withdrawal is due to an immediate and heavy financial need;
  2. Withdrawal is necessary to satisfy that need (i.e. you have no other funds or way to meet the need);
  3. Withdrawal amount does not exceed the amount needed by you;
  4. You have first obtained all distribution or nontaxable loans available under the 401k plan; and
  5. You cannot contribute to the 401k plan for 6 months following the withdrawal.

According to the IRS, a 401k distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:

  1. 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;

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

  3. Payment of 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, or dependents;

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

  5. Funeral expenses; or
  6. Certain expenses relating to the repair of damage to the employee’s principal residence.

 

Hardship withdrawals are subject to income tax, and if you are not at least 59½ years of age, the 12.5% combined Federal and State 401k withdrawal penalties as well.

For example,

If you take a $40,000 hardship withdrawal, you will owe $11,200 in federal income taxes (28% tax bracket), $3,720 in state income tax (9.3% tax bracket) and an additional $4,000 for federal penalty and $1,000 for the state penalty.  You'll be left with $20,080 which is about ½ of your withdrawal.  Not that fun when your government takes ½ of your money and profits from your misfortune.  Remember that when you vote next time.

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