It’s been a challenging year. Between inflation, job losses, and the fear of a recession, we’re all feeling our belt tighten a little bit more as expenses pile up.
I live in Maryland and a lot of my friends and neighbors have been affected by the layoffs in the federal government. It’s affected private government contractors as well.
One place that some people have begun turning to is their 401(k). If you can’t rely on an emergency fund, it may make sense to turn to your 401(k) help bridge the gap and, in the face of hardship, you could get access to it.
Vanguard, before it sold its retirement plan business to Ascensus, reported that 3.6% of its 5 million plan participants took a hardship withdrawal in 2023. Bloomberg reported that according to data from Empower, 15%-20% more people are taking hardship withdrawals.
It’s a big jump during a difficult time.
One important point is worth noting though – a third of the hardship withdrawals were for less than $1,000. People are taking a withdrawal but taking as little as possible.
Before you make any financial decisions, speak with a financial advisor who can look at your specific situation and give you targeted advice. If you don’t have one, you can get a free consultation with one at WiserAdvisor.
Here’s what you need to know about hardship withdrawals:
What Is a 401(k) Hardship Withdrawal?
A hardship withdrawal is something your 401(k) may offer but is not required to offer. It lets employees access funds from their 401(k) before retirement and without the usual 10% early withdrawal penalty. Normally, you can access your retirement funds but you are subject to income taxes plus a 10% penalty – with a hardship withdrawal, you only pay taxes.
To qualify, there are several rules you must follow. The basic idea is that there must be an “immediate and heavy financial need.” The IRS gives these examples:
- Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
What to watch out for
First, you owe income taxes on what you withdraw and the funds are considered income, so it could push you into higher brackets. If you’re in the 10% tax bracket, you would pay 10% in taxes on your withdrawal amount – so be sure to keep that aside.
Next, the money you withdraw can never be returned. This means you lose the opportunity for that sum to grow tax-deferred. But given the choice of future returns and being kicked out for not paying rent, the choice is clear.
Hardship withdrawal alternatives
If you need funds, a hardship withdrawal is likely one of the least expensive options but has a huge opportunity cost as your money won’t be invested anymore.
While you could rely on a credit card or a personal loan, you likely considered those options if you were looking at hardship withdrawals. One potential alternative, especially if you are looking for a smaller sum, is a cash advance app. These are fintech apps that loan relatively small amounts and don’t charge you through the nose to do it. They’re not your traditional payday loan companies.
o a financial advisor to fully understand the tax implications and how it affects your retirement outlook.
This should be a last resort
Hardship withdrawals, if offered by your employer, can be a useful tool as long as you recognize the true cost – that your retirement will be impacted and your funds won’t be invested any longer.
But sometimes your only options are bad ones, hopefully this made it clear what you should watch out for when it comes to a hardship withdrawal.
