What Are Acceptable Reasons For A Hardship Withdrawal
The IRS considers the following list of items acceptable reasons for withdrawing money from your 401k under the hardship withdrawal.
The Pension Protection Act of 2006 extended your need for a hardship withdrawal to the needs of your beneficiary, even if the beneficiary is not your spouse or dependent.
- Medical expense: Un-reimbursed medical expenses for you, your spouse, or dependents
- Home purchase: Toward the purchase of your principal residence
- Foreclosure risk: To prevent foreclosure or eviction from your principal residence
- Educational expenses: College tuition and related educational expenses for you, your spouse, or children
- Funeral expenses: Offsetting the cost of final expenses
- Home repair: Certain expenses for the repair of damage to your principal residence
The IRS code will allow hardship withdrawals for the above-mentioned reasons only if you have no other funds or means to fulfill the need, and the withdrawal would be enough to satisfy the need .
You can, however, include the cost of withdrawal in the amount you need.
Thanks to the Bipartisan Budget Act of 2018, youre no longer required to take a loan from your 401k before being able to file for a hardship withdrawal.
Remember: You are not allowed to contribute to your 401k plan for six months after making a hardship withdrawal.
Taking Money Out Of A 401 Once You Leave Your Job
If you no longer work for the company that sponsored your 401 plan, first contact your 401 plan administrator or call the number on your 401 plan statement. Ask them how to take money out of the plan.
Since you no longer work there, you cannot borrow your money in the form of a 401 loan or take a hardship withdrawal. You must either take a distribution or roll your 401 over to an IRA.
Any money you take out of your 401 plan will fall into one of the following three categories, each with different tax rules.
What Are The Tax Implications Of A 401k Hardship Withdrawal
If you must make a hardship withdrawal from your 401k before you reach the age of 59 and a half years old, your withdrawal will be subject to income tax and a 10% withdrawal penalty.
You dont have to pay back the money withdrawn like you would a loan from a 401k, which means your retirement account balance is permanently reduced by the amount of your hardship withdrawal.
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Borrowing From Your 401k
Another option with a 401k is to take out a loan. Your loan can be up to $50,000 or half the value of the account, whichever is less. As long as you can handle the payments , this is usually a less expensive option than a straight withdrawal. Though you will pay interest, you wont pay taxes or penalties on the loan amount.
A few things to know about 401k loans:
- Since youre incurring debt and will need to make monthly payments on the loan, your ability to get a mortgage may be affected.
- The interest rate on 401k loans is generally about two points above the prime rate. The interest you pay, however, isnt paid to the company it goes into your 401k account.
- Many plans give you only five years to repay the loan. In other words, if you borrow a large amount, the payments could be substantial.
- If you leave your company, you may be required to pay back the outstanding balance within 60 to 90 days or be forced to take it as a hardship withdrawal. This means youll be hit with taxes and penalties on the amount you still owe.
- If payments are deducted from your paycheck, the principal payments will not be taxed but the interest payments will. Since youll be taxed again on withdrawals during retirement, the interest payments will end up being double-taxed.
Take An Early Withdrawal
Perhaps youre met with an unplanned expense or an investment opportunity outside of your retirement plan. Whatever the reason for needing the money, withdrawing from your 401 before age 59½ is an option, but consider it a last resort. Thats because early withdrawals incur a 10% penalty on top of normal income taxes.
While an early withdrawal will cost you an extra 10%, it will also diminish your 401s future returns. Consider the consequences of a 30-year-old withdrawing just $5,000 from his 401. Had the money been left in the account, it alone would have been worth over $33,000 by the time he turns 60. By withdrawing it early, the investor would forfeit the compound interest the money would accumulate in the years that follow.
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Key Considerations With 401 Loans
- Some plans permit up to two loans at a time, but most plans allow only one and require it be paid off before requesting another one.
- Your plan may also require that you obtain consent from your spouse/domestic partner.
- You will be required to make regularly scheduled repayments consisting of both principal and interest, typically through payroll deduction.
- Loans must be paid back within five years .
- If you leave your job and have an outstanding 401 balance, youll have to pay the loan back within a certain amount of time or be subject to tax and early withdrawal penalties.
- The money you use to pay yourself back is done with after-tax dollars.
Although getting a loan from your 401 is relatively quick and easy, the benefit of paying yourself back with interest will likely not make up for the return on investment you could have earned if your funds had remained invested.
Another risk: If your financial situation does not improve and you fail to pay the loan back, it will likely result in penalties and interest.
The 401 Withdrawal Rules For People Older Than 59
Most 401s offer employer contributions. You can get extra money for your retirement, and you can keep this benefit after you change jobs as long as you meet any vesting requirements. Thats an important advantage that an IRA doesnt have. Stashing pre-tax cash in your 401 also allows it to grow tax-free until you take it out. Theres no limit for the number of withdrawals you can make. After you become 59 ½ years old, you can take your money out without needing to pay an early withdrawal penalty.
You can choose a traditional or a Roth 401 plan. Traditional 401s offer tax-deferred savings, but youll still have to pay taxes when you take the money out. For example, if you withdraw $15,000 from your 401 plan, youll have an additional $15,000 in taxable income that year. With a Roth 401, your contributions come from post-tax dollars. As long as youve had the account for five years, Roth 401 withdrawals are tax-free.
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Series Of Substantially Equal Payments
If none of the above exceptions fit your individual circumstances, you can begin taking distributions from your IRA or 401k without penalty at any age before 59 ½ by taking a 72t early distribution. It is named for the tax code which describes it and allows you to take a series of specified payments every year. The amount of these payments is based on a calculation involving your current age and the size of your retirement account. Visit the IRS website for more details.
The catch is that once you start, you have to continue taking the periodic payments for five years, or until you reach age 59 ½, whichever is longer. Also, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!
Are You Still Working
You can access funds from an old 401 plan after you reach age 59 1/2 if you’re still working, but you may not have the same access to the funds at the company for which you currently work if you’ve changed jobs.
Check with your 401 plan administrator to find out whether your plan allows what’s referred to as an in-service distribution at age 59 1/2. Some 401 plans allow this, but others don’t.
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You May Have To Sell Investments At A Bad Time
Pulling cash out of investment accounts after the market has fallen means youre locking in any losses youve incurred. Even if you reinvest these funds down the road, youll have missed reaping any gains those investments would have seen in the interim.
In 2020, the S& P 500 had its largest first-quarter decline in history, finishing down 20%. Stats like this can lead to panic selling, or, coupled with the loosened withdrawal rules, may tempt you to dip into retirement accounts to prevent further losses.
But remember: You havent lost anything until you sell. So if your cash crunch isnt an emergency, you can avoid losses by riding out the storm, and benefit from the rebound whenever it eventually occurs.
Request A Hardship Withdrawal
In certain circumstances you may qualify for whats known as a hardship withdrawal and avoid paying the 10% early distribution tax. While the IRS defines a hardship as an immediate and heavy financial need, your 401 plan will ultimately decide whether you are eligible for a hardship withdrawal and not all plans will offer one. According to the IRS, you may qualify for a hardship withdrawal to pay for the following:
- Medical care for yourself, your spouse, dependents or a beneficiary
- Costs directly related to the purchase of your principal residence
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for you, your spouse, children, dependents or beneficiary
- Payments necessary to prevent eviction from your principal residence or foreclosure on the mortgage on that home
- Funeral expenses for you, your spouse, children or dependents
- Some expenses to repair damage to your primary residence
Although a hardship withdrawal is exempt from the 10% penalty, income tax is owed on these distributions. The amount withdrawn from a 401 is also limited to what is necessary to satisfy the need. In other words, if you have $5,000 in medical bills to pay, you may not withdraw $30,000 from your 401 and use the difference to buy a boat. You might also be required to prove that you cannot reasonably obtain the funds from another source.
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Who Should Withdraw From Their 401 Early
Just because you qualify for a hardship-related withdrawal doesnt mean you should take one without weighing all your other options.
The experts we spoke with were all in agreement that withdrawing from your 401 shouldnt be your first move. However, they also indicated that if youre truly in need, then you should take advantage of the CARES Acts allowances.
It should be a last resort option. People shouldnt get carried away and start using their 401 assets just because they can, Pfau says.
Those Who Can Pay Themselves Back
Its not free money. You have to pay it back or risk getting hit with a hefty tax bill, says Jeff Levine, of Nerds Eye View, an online news source that caters to financial planners.
Someone who may not be able to pay it back should think a little harder about whether they should tap into their retirement assets or not, Pfau says.
Another thing to keep in mind is how close you are to retirement. For many people, this could force them into an early retirement. Borrowing from their 401 may just be a way of actually starting to take distributions for retirement earlier, Pfau says. You just have to recognize the trade-offs, like not having as much money for retirement down the road.
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Who Is Eligible For Coronavirus
If you, your spouse or a dependent have been diagnosed with COVID-19, you qualify for the above benefits. However, eligibility for coronavirus-related distributions extends well beyond those who have been diagnosed.
According to an IRS notice issued on June 19, qualified individuals include anyone who has encountered “adverse financial consequences” as a result of the individual, the individual’s spouse or a member of the individual’s household experiencing any of the following due to COVID-19:
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Being quarantined, furloughed or laid off.
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Having their hours at work cut.
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Having a job offer rescinded or delayed or their income reduced.
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Being unable to work because of a lack of child care.
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Slashing operating hours or shutting down a business due to the outbreak.
This means that if your spouse experiences financial hardship, you may qualify for a coronavirus-related distribution from your retirement account, even if you’re still employed.
Is It A Good Idea To Use The Rule Of 55
Just because you can take distributions from your 401 or 403 early doesn’t mean you should. Depending on your financial situation, it might be better to let your money continue to grow. Holding off withdrawals could help you better position yourself for a financially sound future. If you’re tempted to withdraw retirement funds before you’re eligible, instead consider finding another job, drawing from your savings or using other sources of income until you need to tap into your retirement savings.
If you decide to begin withdrawing funds from your 401 early, the long-term value of your portfolio will likely decrease. It’s essential that you time your withdrawals carefully and take into account how much they would cost you in taxes. To create a strategy that makes sense in your situation, consider working with a financial advisor or a retirement planner.
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Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
Taking Money Out Of A Retirement Account May Have Financial Penalties
There are different rules on early withdrawals depending on the type of account. The type of account you want to take money out of will determine the penalties.
401
You maybe able to withdraw funds from your 401 via a loan or hardship withdrawal, but there may be plan limitations on these withdrawals. Note loans must be repaid, and hardship withdrawals are subject to a 10% penalty and income tax. If you have a 401 plan from a previous employer you may be able to access that savings with less restrictions but early withdrawals before age 59 1/2 are subject to the same 10% penalty and income taxes.
Traditional IRA
Traditional IRAs are subject to similar penalties and taxes on distributions as the 401 is, but the exceptions are a little more relaxed. For example, first time home buyers can take out $10,000 from their Traditional IRA without paying the 10% fees. You do still need to pay income tax on this withdrawal though. The same applies for qualified education expenses and health insurance premiums while unemployedyou wont pay the 10% fee, but you will pay income taxes.
Roth IRA
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How Much Can I Take Out Of My 401k Without Paying Taxes
The amount borrowed is not subject to ordinary income tax or early-withdrawal penalty as long as it follows the IRS guidelines. The IRS provides that 401 account holders can borrow up to 50% of their vested account balance or a maximum limit of $50,000.
How Does A 401 Withdrawal Work
A 401 plan is a retirement option offered by employers, which gives employees a tax break on money set aside for their golden years. Depending on the employer’s 401 plan, contributions made to retirement savings could be matched by employer contributions. Typically, employers match a percentage of an employees contributions, up to a certain portion of their salary.
One provision from The CARES Act allows investors of any age to withdraw as much as $100,000 from retirement accounts including 401 plans and individual retirement accounts this year without paying an early withdrawal penalty of 10%. They can avoid taxes on the withdrawal if the money is put back in the account within three years. If it isn’t returned, taxes can be paid over a three year span.
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A Deeper Dive On The 401 Loan Option
A loan is more strategic than a withdrawal, which torpedoes your savings altogether. With a full cash-out, instantly you lose a big chunk, paying a 10% penalty to the IRS if you leave the plan under age 55 plus another 20% for federal taxes. For instance, with a $50,000 withdrawal, you may keep just $32,500 and pay $17,500 in state and federal taxes. And the leftover sum you receive, if you happen to be in a higher tax bracket, may nudge you into paying even more taxes for that additional annual income.
Another adjustment in 2020 for workers affected by COVID-19: If your plan allows or through your IRA, you can withdraw up to $100,000 without the 10% penalty even if youre younger than 59½. The standard 20% federal tax withholding does not apply, but 10% withholding will unless you decide otherwise. You also can spread your income tax payments on the withdrawal over three years.
We understand emergencies can leave people with limited choices. Just remember that even the less extreme option of a 401 loan may paint your future self into a corner. The most severe impact of a 401 loan or withdrawal isnt the immediate penalties but how it interrupts the power of compound interest to grow your retirement savings.
At the very least, dont start stacking loans . Some employer retirement plans allow as many as three.
