The victims of Hurricane Sandy may have thought they were receiving help from an unusual source – the IRS. Last year the IRS Announcement 2012–44 granted relief in the form of hardship distributions. This was a special exemption that waived the penalty on early withdrawals from IRAs (before age 59 ½) for hurricane victims living in designated areas. Please note this exemption was not granted to any hurricane victim. This was a specific exemption for people living in a specific geographic location affected by a specific natural disaster.
Hurricane Sandy victims who took advantage of the IRS’s benevolence and accessed their IRA funds are now discovering the IRS was not so generous. The hardship distribution waives the penalty but not the tax. The amount of their withdrawal will still be included as taxable income in the year it was taken. A hurricane victim in the 25% tax bracket will owe $2,500 on April 15th for the $10,000 withdrawal they pulled from their IRA. Taking hardship withdrawals from retirement accounts often leads to another form of hardship at tax time.
Hardship withdrawals from an IRA are unusual but it is a standard provision in most company retirement plans like 401(k)s and 403(b)s. The withdrawal may be difficult to get, and costly because of taxes and penalties. Taking a hardship withdrawal should always be a last-resort source of cash for emergencies.
Your retirement plan – IRA, 401(k), Profit Sharing, etc. – enjoys special tax treatment because it is meant to grow over your working career to be used only during retirement. Congress was concerned that workers would not be able to resist accessing money. They built penalties into the rules to discourage early withdrawals. Congress also added strict rules defining hardships to make it difficult to get at the funds. A hardship withdrawal must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. Examples of expenses deemed to be immediate and heavy include:
- certain medical expenses;
- costs relating to the purchase of a principal residence;
- tuition and related educational fees and expenses;
- payments necessary to prevent eviction from, or foreclosure on, a principal residence;
- burial or funeral expenses; and
- certain expenses for the repair of damage to the employee’s principal residence.
In addition to tough federal rules, you may also have to contend with a strict set of withdrawal rules from your employer. Employers will require a proof of need or a process called self-certification. Taking a hardship withdrawal may also exclude you from participating in the plan for some period of time.
The IRS imposes an early withdraw penalty of 10 percent for taxpayers younger than 59 1/2. The penalty is in addition to the tax due. Taxpayers in the 25% bracket would owe $2,500 tax plus $1,000 in penalty on a $10,000 hardship withdrawal.
Besides the Hurricane Sandy penalty exemption, there are other permanent penalty exemptions:
- You have unreimbursed medical expenses that are more than 7.5% of your adjust gross income (10% in 2013 and after).
- You, but not a family member, are deemed totally and permanently disabled.
- The distribution is due to an IRS levy.
- You took the distribution as a military reservist called to active duty.
Keep in mind the exemption only applies to the penalty. There is never an exemption for the tax. The amount of the withdrawal will be included in your taxable income. You could have very little other taxable income so your deductions and personal exemptions shelter the amount of withdrawal resulting in zero tax.
Taking a hardship withdrawal from your retirement account should be a last resort. Make saving for retirement a priority. The longer the money is left to grow in your IRA or 401(k), the easier it may be to reach your goal. You can avoid taking a hardship withdrawal from your retirement funds by building up your after-tax savings. Always keep adequate funds on hand to meet emergency spending needs. This will require careful budgeting and discipline.
- Hardship withdrawals may meet the penalty free exemption definition but they are never tax-free.
- Qualifying for a hardship withdrawal is not easy and may require proof of the hardship or a certification.
- Also keep an emergency cash fund on hand to avoid ever needing to take a hardship withdrawal.