Ask the Adviser: What Do I Need to Know About a Hardship Withdrawal From My Retirement Plan?

Withdrawing money early from a retirement account is a serious decision and is generally best considered only after other options have been reviewed. Rules for accessing retirement savings before retirement have changed since this article was first published. Here is an updated look at the rules and how a withdrawal could affect your overall financial plan.

What Qualifies as a Hardship Withdrawal vs. a Penalty Exception?

The temporary CARES Act relief that applied during 2020 has expired. However, more recent legis­lation, partic­u­larly SECURE 2.0, added permanent excep­tions that may reduce or eliminate the 10% additional tax on early distri­b­u­tions in limited situations.

It is important to distin­guish between a hardship withdrawal, which may allow access to funds in an employer-sponsored plan for an immediate and heavy financial need, and an exception to the 10% additional tax. Quali­fying for a hardship withdrawal does not neces­sarily mean the distri­b­ution is exempt from the additional tax.

In many cases, a hardship distri­b­ution is taxable as ordinary income and may also be subject to the 10% additional tax if the partic­ipant is under age 59 ½ and no exception applies. For a $10,000 taxable withdrawal, for example, a taxpayer in the 22% federal income tax bracket could owe $2,200 in federal income tax plus a $1,000 additional tax, before consid­ering state taxes or the effect of the distri­b­ution on other items on the tax return.

Retirement accounts and plans such as IRAs, 401(k)s, 403(b)s, profit-sharing plans, and similar arrange­ments receive favorable tax treatment because they are intended to fund retirement. However, hardship distri­b­ution rules generally apply to employer-sponsored plans, not IRAs. Employer-sponsored plans are not required to offer hardship distri­b­u­tions. If a plan does allow them, the plan document sets the terms and must comply with IRS rules.

For a 401k hardship withdrawal, the distri­b­ution generally must be made because of an employee’s “immediate and heavy” financial need and must be limited to the amount necessary to satisfy that need, including amounts needed to pay taxes and penalties resulting from the withdrawal. IRS safe harbor categories generally include:

• Certain medical expenses
• Tuition and related educa­tional fees and expenses for up to the next 12 months of postsec­ondary education
• Costs directly related to purchasing a primary residence, excluding mortgage payments
• Payments necessary to prevent eviction from, or foreclosure on, a principal residence
• Certain funeral expenses
• Certain expenses to repair damage to a principal residence
• Certain expenses and losses related to a federally declared disaster.

Plans may impose additional admin­is­trative require­ments, SECURE 2.0 generally allows admin­is­trators of 401(k), 403(b) and govern­mental 457(b) plans to rely on an employee’s certi­fi­cation that applicable hardship require­ments are met, unless the admin­is­trator has actual knowledge to the contrary. Partic­i­pants should retain records supporting the need, amount, and timing of the distribution.

A hardship withdrawal does not automat­i­cally avoid the 10% additional tax. The hardship distri­b­ution rules and the excep­tions to the additional tax are separate, and not every exception applies to every type of retirement account or plan.

Depending on the type of retirement account or plan excep­tions may include:

• Certain unreim­bursed medical expenses above the applicable adjusted gross income threshold
• Total and permanent disability of IRA owner or participant
• The distri­b­ution is made 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
• Qualified birth or adoption distri­b­u­tions, generally up to $5,000 per child for eligible expenses
• Domestic abuse victim distri­b­u­tions, generally up to the lesser of the inflation-adjusted dollar limit or 50% of the vested account balance
• Qualified disaster recovery distri­b­u­tions, generally up to $22,000 for eligible individuals who sustain an economic loss because of a federally declared disaster.

These excep­tions generally apply only to the 10% additional tax, not to ordinary income tax. Some special distri­b­u­tions may be eligible for repayment within three years, but tradi­tional hardship withdrawals generally cannot be rolled over or repaid to the plan. Rules differ among IRAs, 401(k)s, 403(b)s, and govern­mental 457(b) plans. Review the plan documents and consult a qualified tax profes­sional before acting.

An early or hardship withdrawal from a retirement account is generally best treated as a last resort. The immediate tax cost can be signif­icant, but the larger cost may be the lost years of compounding on finances intended for retirement. Before taking a withdrawal, consider alter­na­tives such as emergency savings, nonre­tirement invest­ments, spending changes, insurance proceeds, employer benefits, or if the plan permits and it is appro­priate for your circum­stances, a retirement plan loan.

Origi­nally Posted On April 27, 2022