In 2020, due to the pandemic, the CARES Act temporarily amended the rules for taking early distributions from retirement savings plans. This included both employer-sponsored plans, like 401(k)s and 403(b)s, and individual retirement accounts (IRAs). Essentially, account holders could withdraw up to $100,000, even if they hadn’t reached the minimum age of 59 ½. These distributions weren’t subject to the 10% penalty that’s usually applied to early withdrawals. The withdrawals were still treated as regular income, and the account owner had to pay ordinary taxes on the funds. However, a special provision in the CARES Act allowed the income to be spread over up to three years rather than being taxed in a single year.
Withdrawing money early from a retirement savings account is a serious decision, whether or not we’re in a global pandemic. The decision carries consequences—namely, having to pay a 10% penalty on the money withdrawn, in addition to income taxes. For a $10,000 hardship withdrawal, for example, taxpayers in the 22% bracket would owe $1,000 in penalties plus $2,200 in income tax.
Your retirement plan (IRA, 401(k), profit-sharing plan, or other) enjoys special tax treatment because it’s meant to grow throughout your career for use during retirement. Historically, out of concern that workers wouldn’t resist accessing the funds, Congress created penalties to discourage early withdrawals. Congress also added strict rules to define hardships, making it difficult to get the funds.
By definition, a hardship withdrawal must be due to an employee’s “immediate and heavy” financial need, and the amount must be necessary to satisfy the financial need. Examples of immediate and heavy expenses include:
- Certain medical expenses
- Tuition and related educational fees and expenses
- Payments necessary to prevent eviction from, or foreclosure on, a principal home
- Burial or funeral expenses
- Expenses to repair damage to a principal home
In addition to strict federal rules, employer plans may have their own withdrawal rules. Employers can require proof of need or ask for a process called self-certification. Taking a hardship withdrawal may also exclude the employee from participating in the plan for a period of time.
While the CARES Act penalty exemptions were temporary, seven permanent exemptions exist. Account owners don’t have to pay penalties in the following scenarios:
- Unreimbursed medical expenses are more than 7.5% of the account owner’s adjusted gross income
- The account owner becomes totally and permanently disabled
- The distribution is due to an IRS levy
- The distribution is taken by a military reservist called to active duty
- A court order calls for the money to go to a divorced spouse or dependent
- The account owner leaves an employer (via permanent layoff, termination, quitting, or taking early retirement) in the year they turn 55 or older
- A payment schedule is set up to withdraw money in substantially equal amounts over life expectancy
Bear in mind that the exemption only applies to the penalty; there’s never an exemption for the tax. The withdrawal amount is included as taxable income the year it’s withdrawn. A taxpayer with very little other taxable income could end up owing little to no tax on the withdrawal.
Think of an early or hardship withdrawal from your retirement account as a last resort. The longer you leave money in an IRA or 401(k) to grow, the easier it will be to reach your retirement goals. A great way to avoid needing a hardship withdrawal is to build up investments held outside of retirement accounts, and to always have adequate emergency funds on hand.
Rick’s Insights
- Even if hardship withdrawals meet the criteria for penalty-free exemption, they are always subject to income tax.
- Qualifying for a hardship withdrawal isn’t easy and may require proof of the hardship.
- Maintaining an emergency cash fund helps avoid hardship withdrawals.
Originally Posted On March 20, 2013
