If you have been able to build up a sizable fund in a 401(k) or other qualified retirement plan, you have a good head start on a nest egg for retirement. Sometimes, however, extenuating circumstances may force you to tap into your account prematurely. Specifically, you might apply for a “hardship distribution” when the plan permits it. Although you may decide this is your best option, consider all the implications.
Background: You can take a hardship distribution from a 401(k) plan up to the amount of your elective deferrals upon severance from employment, termination of the plan, death or disability, or for a hardship withdrawal. A hardship withdrawal is defined as a distribution made due to an “immediate and heavy financial need.” It is limited to the amount required for that need.
Of course, hardship withdrawals are still subject to federal income tax in the year they are paid out. To qualify as a hardship withdrawal, the distribution may be used in any of the following situations:
- Medical expenses of an employee, his or her spouse, or a dependent;
- College tuition and certain other education fees of an employee, his or her spouse, or a dependent;
- Expenses to purchase a principal residence for an employee (excluding mortgage payments);
- Expenses to stave off eviction or foreclosure of the employee’s principal residence;
- Burial or funeral expenses for an employee’s deceased parent, spouse, child or dependent; or
- Expenses for repairing casualty damage to an employee’s principal residence (e.g., as a result of a hurricane or other natural disaster).
Note that similar rules apply to other tax-qualified plans permitting elective deferrals, such as a 403(b) plan offered to employees of a tax-exempt organization.
However, to discourage these hardship withdrawals early in your career, the IRS imposes a 10% penalty tax if you are younger than age 59½, unless a special exception applies. The penalty tax does not apply in the following situations:
- You are totally disabled.
- You pay for medical expenses exceeding 10% of your adjusted gross income.
- You are required by a court order to give money to your divorced spouse, a child or a dependent.
- You separate from service (through quitting, retirement, termination or layoff) in the year you turn age 55, or later.
- You separate from service and establish a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution, you are required to continue for five years or until you reach age 59½, whichever is longer.)
Employers are not required to offer hardship withdrawals, so check to see if this option is available to you. Then consider all the economic ramifications of such a distribution. Finally, remember that your 401(k) or other plan is meant to be used for retirement saving.
Looking for more retirement tax planning expertise? Contact Donald G. Chastain, CPA by calling (334) 887-7022 or by leaving us a message below.