With a 401k plan, you are generally forbidden from taking a disbursement from it until you reach the age of 59.5.
Of course, the primary reason to save in the 401k plan is to have tax-deferred growth on your investments. Leaving that balance alone gives you the best option to build the value of the account to use during your retirement years.
If you encounter a qualifying hardship, however, you may have the option of taking a 401k loan out on what you’ve saved or a hardship withdrawal.
It is important to understand the financial implications of both options before deciding which one may be right for you.
What Happens When You Take Out a 401k Loan?
If you are not in a place of financial hardship, but it would be useful to have some extra cash, then a 401k loan is an option to consider. Under current IRS rules, you are allowed to borrow up to 50% of your vested account balance, up to a maximum of $50,000 – whichever is the lesser amount.
This is not considered a disbursement. It is a loan that you must repay.
The good news is that when you make loan payments, you’re paying yourself back. That’s a definite positive. Because the loan has an interest rate associated with it, you can make up some of the difference in the earnings you’re not getting with the full amount of cash in your plan.
The bad news is that if you leave your job before the 401k loan is fully repaid, the remaining balance is treated as a distribution. That means you’ll be paying an early withdrawal penalty of 10% on whatever was due.
Any remaining balance from a 401k loan is also treated as income, which could push you into the next income bracket.
Although a 401k loan should not be considered a first option, there are some reasons why a loan could be useful.
- It could help you consolidate high-interest debt when your credit score is too low to qualify for debt consolidation products or an introductory credit offer.
- You could use the loan as a source of money when trying to make a down payment on a new home.
- It could be used to make an investment when your regular income will not cover the amount that is required.
- You could treat is as money that comes your way ahead of schedule if your retirement cushion is already where you want it to be.
A 401k loan must usually be repaid within 5 years of the disbursement. There are IRS provisions which allow the administrator of the 401k to extend the repayment period if you use the funds to purchase a home.
What Happens with a 401k Hardship Withdrawal?
In the United States, a hardship withdrawal from a 401k plan is only allowed when there is a heavy, immediate financial need. The amount of the hardship withdrawal must be for the amount that fills that need and nothing more.
If you decide to make the hardship withdrawal, you are still going to be subjected to ordinary income tax, based on your income bracket, along with a 10% early withdrawal penalty if you are under the age of 59.5 at the time it occurs.
The withdrawal penalty is paid as part of your annual tax return if the amount is not automatically deducted by the retirement plan administrator who transfers the funds to you.
There are some safe harbor exceptions to the hardship withdrawal rules for 401k plans when the heavy expenses are associated to certain events. The IRS waives the 10% early withdrawal penalty when you need to purchase health insurance or need to take out money because you’ve experienced an extended run of unemployment.
These circumstances may also qualify you for the safe harbor exception for a hardship withdrawal to avoid the 10% penalty.
- School-related costs, including tuition, fees, and expenses for post-secondary education activities which involve you, your spouse, your children, dependents, or beneficiaries.
- Payments that are required to prevent you from being evicted from your primary residence, including the prevention of a foreclosure.
- Funeral expenses that are directly related to immediate household needs.
- Certain household repair expenses that are made to the principal residence.
Common household repairs are not generally covered by the safe harbor stipulation. Only home repairs that result from a casualty loss, which includes flooding, fire damage, or storm damage, and have costs not covered by your homeowner’s insurance policy, will generally qualify for the 10% early withdrawal penalty from being waived.
Even with a qualifying hardship expense, most plans only allow you to take out what you put into the plan in the first place. Any contributions not made by you or earnings made within the plan are not generally eligible for withdrawal.
How to Provide Proof of a Hardship
If you are thinking about a hardship withdrawal from your 401k plan, then you must be able to explain your situation to the administrator of your retirement plan. Most administrators will qualify you based on the conversation you have with them.
There are times, however, when some form of documentation may be required before the hardship withdrawal will be permitted. Each circumstance is unique, so be sure to ask what proof of hardship will be necessary to complete the withdrawal.
You may be asked to provide photographic evidence of home repairs, documentation from your mortgage lender about a down payment, or a current bank statement showing the current status of your regular financials.
In most situations, proving a financial hardship means having clear documentation of your income and basic living expenses. Although pay stubs or a W-2 form can provide some of this information, you may be asked to provide up to 3 years of income tax returns.
You might also be asked to provide copies of your current expenses, including property tax bills, utility bills, and other miscellaneous responsibilities.
If your hardship withdrawal is needed for qualifying home repairs, you will likely be asked to provide an estimate from the contractor, a copy of your homeowner’s policy, and photographic evidence of the damage which occurred.
How to Repay a 401k Loan or Hardship Withdrawal
Because a 401k loan is essentially borrowing from yourself, you will be repaying the 401k plan with after-tax payments. Some plan administrators may require your payments to be automatically deducted from your paycheck.
That means you’ll want to know what the repayment terms happen to be. You may be asked to make a monthly payment. If you get paid weekly, however, you mind find that 25% of the monthly payment gets taken out of each paycheck.
Using the $50,000 maximum for a 401k loan, using 24 payments per year, a 4-year loan at a 4.25% interest rate would require payments of about $570.
You are usually permitted to repay the loan early. Most early repayment options require a single lump-sum payment, sometimes only for the remaining balance, so it may not be an option for everyone.
If automatic deductions do not occur, you may be sent a paper or electronic invoice each month to pay the loan back. You may also be asked to setup an ACH withdrawal from your checking account for the payment schedule you’ve agreed upon with your 401k loan.
With a hardship withdrawal, you are not utilizing a loan. You are utilizing an early disbursement, even if you have a safe harbor qualifying event. That means you are not permitted to pay the money back into the retirement account.
Once you take a hardship withdrawal, you are not permitted to make contributions to your 401k plan for 6 months. After the 6-month waiting period expires, you can once again contribute the annual maximum allowed to the 401k plan.
What many people do not realize is that the funds in a 401k plan are protected from bankruptcy procedures. If you are in a place of financial hardship, then cashing out your 401k makes your money available to your creditors.
If you were to leave the money in the 401k plan, then it would be protected.
For those thinking about a hardship withdrawal because of their debt status, it is usually better to try working out a payment plan with a creditor before thinking about an early withdrawal, even if it is a qualifying one that won’t charge the 10% penalty.
401k Loans vs Hardship Withdrawals: Which is Better?
As a general rule, it is best to leave the funds in your 401k alone.
There are times when this may not be possible. If you must take money from your retirement account, the next best option is to take a 401k loan.
With the loan, you’ll get to repay yourself without having a 6-month waiting period imposed. You’ll also avoid the threat of a 10% early withdrawal penalty unless you leave your job before the loan is fully repaid.
If you have a qualifying hardship, the IRS waives the 10% early withdrawal penalty, which will limit your costs to access your cash. You’ll also be prevented from making new contributions for 6 months, which means the growth of your 401k plan will be limited.
Each situation is different. Evaluate both possibilities, then decide which option will best meet your needs.