Understanding 401(k) hardship withdrawal: Rules and consequences

A 401(k) hardship withdrawal can offer a much-needed financial lifeline during an emergency. Prematurely withdrawing from your retirement plan typically comes with a 10% penalty, but hardship withdrawals offer a valuable exception to this rule.

As one of the best retirement plans for long-term savings, the IRS imposes strict guidelines on 401(k) withdrawals. The financial hardship must be unexpected, immediate, and not covered by insurance to be qualifiable.

Here's everything you need to know about qualifying for a hardship withdrawal from your 401(k) plan.

What is a 401(k) hardship withdrawal?

Definition and purpose of 401(k) hardship withdrawal

A 401(k) hardship withdrawal is a penalty-free way to withdraw funds from your 401(k) before age 59½ in the event of "immediate and heavy financial need," as stated by the IRS. Unlike a personal or 401(k) loan, you don't need to repay the funds.

According to Vanguard's "How America Saves 2024 " report, more people took out hardship withdrawals in 2023 than in 2022. However, most 401(k) plan participants did not take out a hardship withdrawal. 

Withdrawing from your 401(k) plan, even penalty-free, can have long-term financial consequences. A hardship distribution can hurt your overall growth potential. So, it's best to avoid taking out a hardship withdrawal unless it's your last resort.

Situations that qualify for a hardship withdrawal

The following situations are eligible for a 401(k) hardship withdrawal: 

• To purchase a principal residence
• To repair a principal residence in the event of losses from floods, fires, or earthquakes
• To prevent eviction or foreclosure
• To cover medical care expenses for yourself, a spouse, or a dependent
• To pay for tuition and other educational expenses for yourself, a spouse, or a dependent (up to 12 months' worth)
• To pay for funeral or burial expenses for a spouse or dependent

Remember, you are still responsible for certain tax obligations, such as paying income tax on the amount withdrawn if the original contributions were tax-deferred. 

Rules on 401(k) hardship withdrawals

Here are the 401(k) hardship withdrawal rules:

• You must be younger than 59 ½ and be still employed with the business sponsoring your 401(k) plan. 
• You are limited to two hardship distributions per plan year.
• You can't request more than the necessary amount to relieve you of your financial hardship. 
• There's a $1,000 withdrawal minimum. However, you won't qualify for a withdrawal if your vested 401(k) balance is less than $1,000.

What are 401(k) hardship withdrawal qualifications?

There are specific 401(k) hardship withdrawal eligibility requirements to be aware of. First, both your plan provider and employer must allow hardship withdrawal. Not all plan providers or employers enable employees to make a hardship withdrawal from their 401(k), even if the employee's situations align with IRS criteria.

You must also demonstrate that you have exhausted all other available financial resources, such as savings accounts, brokerage accounts, and other liquid assets. Similarly, if you have an insurance policy that covers emergency expenses, you won't be able to take a hardship distribution. 

How to apply for a 401(k) hardship withdrawal

You may be able to apply online or in person for a 401(k) hardship withdrawal through your plan sponsor or your employer. While the IRS manages the policies and rules around hardship withdrawals, individual plan sponsors and employers have their own policies.

If your plan does allow hardship withdrawals, make a request that can be approved by a representative or by a committee, who will then take legal responsibility for the 401(k) withdrawal.

You may need to supply supporting documentation of your hardship, including legal documents, invoices, and bills. Although the IRS does not approve hardship withdrawals from 401(k)s, you may still be audited. So, ensure all your ducks are in a row if you are permitted a 401(k) hardship withdrawal. 

You typically don't need additional 401(k) hardship withdrawal documentation besides the application, which can be reviewed in 5-7 business days. 

Drawbacks of 401(k) hardship withdrawals

Qualifying for a 401(k) hardship withdrawal can be difficult, as the rules are generally strict. Just because you can technically pull from your 401(k) doesn't mean you should.

Depleted retirement savings

While a hardship withdrawal may provide immediate relief, it can be a major setback to your retirement savings. 401(k)s are retirement accounts designed to grow via compound interest over a longer period while investing funds in a diverse portfolio of assets.

Removing funds from a 401(k) not only depletes your retirement savings, but also stops your money from continuing to earn interest. Depending on how much you need to retire, this could significantly affect your retirement planning goals. 

Tax implications of 401(k) hardship withdrawals

Consider the tax obligations involved with 401(k) hardship withdrawal before taking out money. Since 401(k)s are tax-advantaged plans, you may have to forfeit your tax advantages if you withdraw early. Hardship withdrawals are taxable income, which may place you in a higher tax bracket.

The 401(k) administrator may also withhold at least 20% of the requested amount from your 401(k) for tax purposes. The amount withheld varies by income. 

Alternatives to 401(k) hardship withdrawals

Before resorting to a 401(k) withdrawal, consider alternative options like a personal loan or 401(k) loan. While these alternatives may involve interest payments, they can be more sustainable in the long run than depleting your retirement savings.

Hardship withdrawal vs. a 401(k) loan

A 401(k) loan allows you to borrow from your retirement savings, with interest, for a specific period. Unlike a hardship withdrawal, 401(k) loans can be used for any financial need, offering flexibility.

The benefit of a 401(k) loan over a hardship distribution is that repaying the principal loan balance, including interest, mitigates some of the negative financial impact of the withdrawal. However, you still miss out on the money's full growth potential if it had been left in the account. 

Moreover, the loan amount is not subject to taxes if repaid according to the loan terms. 

Hardship withdrawal vs. personal loans

Consider a personal loan to avoid early withdrawals from your 401(k). Financial institutions offer lump sum loans with fixed interest rates. Although incurring debt isn't ideal, a personal loan can provide a temporary solution while allowing your retirement savings to continue growing.

A personal loan is a more viable option for employees nearing retirement age. However, taking out a loan requires a hard inquiry, which will lower your credit score. 

FAQs about 401(k) hardship withdrawals

What qualifies as a hardship for a 401(k) withdrawal?

What qualifies for a 401(k) hardship withdrawal is an "immediate and heavy financial need" as defined by the IRS. Certain financial needs for a 401(k) hardship withdrawal can be for yourself, a spouse, or a dependent. This includes money to prevent eviction or foreclosure, medical bills, and tuition or educational expenses.

What are the penalties for 401(k) hardship withdrawal?

A qualifying 401(k) hardship exception avoids the standard 10% penalty typically incurred by early 401(k) withdrawals. However, you are still responsible for paying income tax on the amount withdrawn. 

Can I repay the amount withdrawn from my 401(k)?

You cannot repay the amount withdrawn from your 401(k) if you took a hard withdrawal. Unlike a 401(k) loan, hardship distributions cannot be repaid and may temporarily affect your ability to contribute toward your retirement plan. 

Are there alternatives to taking a hardship withdrawal from my 401(k)?

Alternatives to taking a hardship withdrawal from your 401(k) include taking out a 401(k) loan or personal loan. Consider acquiring funds from other savings accounts or assets before tapping into your retirement savings. A 401(k) hardship withdrawal should be a last resort.