A hardship withdrawal is a type of withdrawal option in some 401(k) plans. As the name implies, if certain financial hardships exist for a plan participant, the participant will be able to take money out of their retirement plan.
A hardship withdrawal provision is an optional feature in 401(k) plans, so not all plans will have them. The options for taking money out of a retirement plan are limited; so many companies include a hardship withdrawal feature as an additional method for participants to access their money. The logic behind including the feature is that more employees will participate in the plan if the plan allows them to withdrawal money for financial problems.
The rules governing hardship withdrawals are generally comprehensive and strict. When 401(k) plans do include a hardship withdrawal feature, they will follow either the Facts and Circumstances or the Safe Harbor set of hardship rules. The Safe Harbor rules require that a participant must meet specific criteria in order to qualify for a hardship withdrawal. The criteria include an immediate and heavy financial need related to six specific events.
One is to pay expenses for medical care for the participant or his or her dependent. Another is to pay for funeral expenses for a deceased parent, spouse, child, or other dependents.
The next three events that could qualify for a hardship withdrawal are related to owning a home. The first is for costs related to the purchase of a primary residence. The next is for amounts needed to prevent being evicted from a primary residence or foreclosing on the mortgage of your primary residence. The third is to pay expenses for the repair of damages stemming from certain disasters such as hurricane Katrina. The last event that could qualify for a hardship withdrawal is to pay for post-secondary education for the participant, participant’s spouse, or participant’s dependent.
In addition to these rules, a participant taking a hardship withdrawal is prohibited from contributing to the plan for at least six months after receiving the withdrawal. The primary reason for this is to deter the participant from taking the withdrawal. Not only will it be more difficult for the participant to reduce taxable income, he or she will also miss out on any employer matching contributions for that period. Due to the ramifications of being unable to contribute for several months, a participant may look elsewhere for the money.
The Facts and Circumstances rules are less defined than the Safe Harbor rules are. Rather than falling back on specific events as outlined by the IRS, employers have to make the determination on whether the participant has incurred a financial hardship. Furthermore, employers need to review all relevant facts and circumstances to determine whether the participant can pay for the hardship using other resources.
Hardship withdrawals are taxed as income in the year withdrawn. They are also subject to a 10% penalty tax. Moreover, many 401(k) plan providers will assess a fee for processing the withdrawal. Therefore a hardship withdrawal should only be considered as a last resort.