If you contribute to a 401k plan at your job, chances are your employer may allow you to make a hardship withdrawal of funds that you have contributed. Not every plan allows hardship distributions, but if yours does, the IRS requires that it must be due to an “immediate and heavy financial need” — which doesn’t mean that you can take a hardship withdrawal from your 401(k) to pay off credit card debt.
Instead, examples of an “immediate and heavy financial need” can include things like medical care expenses, costs related to the purchase of the employee’s main residence, payments necessary to prevent eviction or foreclosure, tuition or fees related to the next 12 months of postsecondary education, or funeral expenses. (See the IRS web site for specifics.)
So when you really need the money, making a hardship withdrawal may seem like a good idea. But is it? Of course you’ll have to judge your own situation for yourself, but I would only make a hardship withdrawal from a 401k plan as a last resort to pay for current and necessary medical care. Here’s why.
First, some of the things listed above — such as buying a home or tuition — can be planned for in advance, and aren’t things that you have to do anyway. It’s possible to wait until you have the money outside of a retirement plan first, and it’s usually a very good idea to do so. Your 401(k) is not a savings account to be tapped at will; it’s a retirement vehicle.
Second, if I were looking at making a hardship withdrawal to pay for medical care that was previously incurred or to prevent eviction or foreclosure, I’d want to be sure I’d exhausted my other options first — things like setting up payment plans, negotiating, and earning extra money that could be used instead.
Once those methods were exhausted, I’d want to think long and hard about whether the withdrawal was actually likely to help in the long run. If it was only a short term fix, and I was likely to end up declaring bankruptcy anyway, I wouldn’t apply for the distribution. That’s because according to this Wall Street Journal article and other sources on the web, retirement accounts are usually protected from creditors to a certain extent in the United States. I wouldn’t want to trade what I’d built up for my future security for a short-term fix that was unlikely to make a lasting difference.
Keep in mind that if you do decide to make a hardship withdrawal from your 401(k), you’ll have to pay income tax on it and pay an 10% additional tax on early distributions. Those aren’t usually withheld for you either, so you could end up short of cash come tax time. Owing the IRS does not sound appealing. You also usually won’t be allowed to contribute to your 401k plan for a period of six months after you make the withdrawal, which makes sense.
So if you’re considering making a 401k hardship withdrawal, be sure you understand all the tax implications and the impact losing out on compounding over time in your retirement account can have on your future.Posted in Retirement on 03.16.11 with 6 comments.