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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.
I can see why employers spend a lot of time scaring off 401k hardship applicants. If the process were easy, everyone would probably consider doing it at least once. I know when my mother passed away, I seriously considered writing a letter of hardship so I could tap into my 401k savings. It was a lot of money to pay all at once, but then I discovered she had some insurance policies I didn't know about and they were enough to cover her funeral expenses.
When I asked my boss about the hardship withdrawal process, he shook his head and said I really didn't need to explore that option unless I was completely tapped out. He said the tax penalties alone were substantial, and I would miss all that money when it came time to claim it later.
I had a friend who needed to claim a 401k hardship withdrawal for medical reasons, and the human resources department gave him unimaginable amounts of grief during the application process. He had to provide a detailed hardship letter, which had to include as many specifics about the medical situation as possible. Who was the patient? What was his or her prognosis? Will he or she need more treatment in the future? Were all of the procedures medically necessary? He had to prove that the only way he could cover the medical debt was through a hardship withdrawal.
After he finished proving his claim, the company was still reluctant to release the funds. An outside 401k specialist came in and
explained all of the potential risks and financial penalties associated with a hardship withdrawal. It was every bit as scary as this article implied. He finally did receive his money, but he told me he would seriously consider applying for a second mortgage or a bank loan if he ever ran into financial difficulties again.