401(k) Hardship Withdrawals vs. Loans

Considering taking a 401(k) hardship withdrawal or loan? It may be tempting to pull funds from your retirement plan, but taking money out of a 401(k) should be considered a last resort. 

There are several good reasons to leave the savings in your 401(k) untouched until you reach retirement: Assets in these accounts have the potential to grow tax free and generate compound growth over time, while early 401(k) withdrawals—that is, before age 59½—could trigger a 10% penalty, as well as income taxes.

While we strongly suggest leaving these assets as a last resort, what if you're facing an "in-case-of-emergency-break-glass" moment of financial stress? Could tapping your 401(k) be an option?

The short answer is maybe. In cases of hardship, you may be able to take a penalty-free early withdrawal from your 401(k)—known, fittingly, as a hardship withdrawal. You can also borrow from your 401(k). Both approaches are subject to a variety of rules and tax regulations, so both plan sponsors and the IRS end up having a say on whether the distribution qualifies for more-lenient treatment.

Here, we'll look at how hardship withdrawal and loans work and what each move might mean for your finances. 

Starting this year, if your employer plan allows, you can withdraw $1,000 from your 401(k) per year for emergency expenses, which the Secure 2.0 Act defines as "unforeseeable or immediate financial needs relating to personal or family emergency expenses." You won't face an early withdrawal penalty, but you will have to pay income taxes and repay the distribution within three years. No additional withdrawals will be permitted until you've fully repaid your distribution. 

But what if that's not enough or if your plan doesn't allow you to use this new provision of the law? You may be able to take a hardship withdrawal from your 401(k), so long as you have what the IRS describes as an "immediate and heavy financial need." In such cases, you may be allowed withdraw only enough to meet that need, penalty-free, though you will owe income taxes.

So, what qualifies as an "immediate and heavy financial need?" The IRS lists the following examples:

• Medical bills for you, your spouse, dependents, or beneficiary.
• Costs directly related to the purchase of your principal residence. Mortgage payments don't count.
• Payments necessary to prevent eviction or the foreclosure of your primary residence.
• Certain expenses to repair damage your principal residence.
• Tuition, educational expenses, including fees, and room and board for the next 12 months of college for you or your spouse, children, dependents, or beneficiary.
• Funeral expenses for you, your spouse, children, dependents, or beneficiary.

As you can see, some of these situations are foreseeable or voluntary, so you needn't have suffered a disaster to qualify. That said, you may need to prove to your employer that you couldn't have met your financial need using your regular pay, an insurance payout, or asset sales. Keep in mind, too, you may have access only to the principal in your 401(k), but not the investment gains. Consult your plan rules to learn more. 

As mentioned, hardship distributions may not be subject to the 10% early withdrawal penalty, assuming your financial need qualifies. (Of course, if you're over 59½, this wouldn't apply.) You aren't allowed to repay the sum you withdraw and can't roll any unused funds over into an IRA. However, you will be allowed to continue contributing to your 401(k) and may still receive employer matching contributions.

It's also important to understand that taking funds out of your 401(k) before retirement could permanently undermine your future financial situation. You won't just be decreasing the savings in your retirement account. You'll also weaken your portfolio's ability to generate future returns, as every dollar taken out of your retirement savings today won't be able to generate potential returns in the future.

Your employer-sponsored plan may also let you borrow from your 401(k), with a limit of up to 50% of your account balance or $50,000, whichever is less. That said, if 50% of the vested account balance is less than $10,000, you can generally just borrow the full $10,000. (Plans aren't required to include this exception.)

As this is a loan, you will you have to repay yourself—with interest. These plans generally give you five years to repay yourself, with payments occurring at least quarterly, but usually every pay period. You may qualify for a longer repayment period if you're using the loan to buy a primary residence.

One thing to keep in mind is that if you leave your job before repaying the loan, you may be required to pay the outstanding balance immediately. If you can't, the IRS could treat the unpaid portion as an early distribution, which would trigger income taxes and a 10% penalty.

This may be begging the question, but if you have other sources of funds available you should generally consider hitting those first. For example:

• Emergency fund: It's always a good idea to keep an emergency fund with three to six months' worth of essential living expenses easily accessible in case of an emergency. In fact, SECURE 2.0 now allows employees to make Roth contributions of up to $2,500 (indexed for inflation) to an emergency savings account connected with their employer retirement plan. Such accounts allow you to automatically set aside money from your paycheck and could minimize the risk of having to tap your 401(k). However, not all plans offer this, so check with your employer. If you don't have access to such an account, you can still save on your own in a savings account or brokerage account. 
• Health Savings Account (HSA): If you're enrolled in a high-deductible health care plan that offers an HSA, that should probably be your first stop if your emergency is related to medical issues. HSAs offer triple tax advantages: Contributions are tax-deductible, earnings are tax-free, and withdrawals are tax-free when used for qualified medical expenses. We generally suggest keeping two to three years' worth of routine medical expenses in cash, cash investments, or similar low-volatility investments in these accounts.
• Regular brokerage account: There's no up-front tax break for holding money in your brokerage account, and income is taxed for the year you earned it. But if you hold assets for more than a year, you may qualify for a lower long-term capital gains tax rate, meaning the tax bite of an emergency withdrawal could be fairly small. Tax-efficient investments (like certain municipal bonds) may also offer tax benefits. Losses may be deductible. And the IRS won't restrict contributions, withdrawals, or how you spend the money.
• Roth IRA: Roth IRA savings should be considered a last resort, tantamount to tapping your 401(k) early, but you can withdraw your contributions—but not gains—at any time with no additional tax or penalty. After age 59 ½, you can withdraw any earnings you've made with no tax or penalty as long as you've held the account for at least five years. As a reminder: Roth IRAs allow you to potentially grow your savings through investments and get specific tax benefits. Because the income you contribute to a Roth IRA account is taxed up front, there's no immediate tax break. But the money you contribute and any potential earnings you make on that money can grow tax-free.

Before taking any of these actions, consider talking with a financial advisor about your situation as well as the potential tax and planning implications of tapping different kinds of assets. If you can avoid touching your retirement funds you'll have the potential for a bigger nest egg for your later years.