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Tapping your 401(k) when you need money and can't repay it

Some millennials tap 401(k)s to pay down debt
Some millennials are using their 401(k)s to pay down debt 01:11

For folks who need money for urgent expenses and don't have the ability to repay it, one option is to look at taking a hardship withdrawal from their 401(k) retirement account

Some employers' 401(k) plans, but not all, allow employees who have a balance in their plan to tap cash from the 401(k) as a hardship withdrawal. Employees considering this need to know that these special withdrawals are different than taking a loan from your 401(k). Hardship withdrawals allow individuals in certain situations to take a distribution from their retirement plan account while they're still working. But taking a hardship withdrawal comes at a cost: Hardship withdrawals are reported as taxable income, and an additional 10% penalty tax can also apply. There's also the negative impact on your retirement savings that will never grow tax-deferred over future decades.

Generally, hardship withdrawals may be taken only if there is an immediate and heavy financial need, the withdrawal is necessary, and you can't get the money needed from any other reasonable source. According to IRS rules, hardship withdrawals are only permitted for specific reasons, which include:

  • Qualified medical expenses that exceed 10% of adjusted gross income
  • The purchase of a primary residence
  • Up to 12 months of qualified education expenses
  • Funeral or burial expenses
  • Home repair expenses due to casualty losses
  • To prevent eviction or foreclosure of a mortgage on a primary residence

While the reasons for taking hardship withdrawals are serious, before you do it you need to know that there are several downsides in respect to taking hardship withdrawals from a retirement plan:

  • The amount distributed is taxed as ordinary income
  • If you are under age 59½, an additional 10% penalty will apply to the amount withdrawn

Another downside is that the money taken as a hardship withdrawal cannot be repaid to your 401(k) account, so this permanently reduces the balance of your retirement savings. 

Also, many employers require you to provide a written explanation of the reason for requesting a hardship withdrawal and why the need cannot be satisfied from other reasonable resources. Revealing these private details to your employer can be awkward.

The good news is that new rules enacted last year make it easier to withdraw a larger amount of your account as a hardship withdrawal. 

Under the prior rules, you could only withdraw the contributions you made to your account and not any of the employer's matching money and investment earnings. Also, when you took a hardship withdrawal you would be barred from making any new contributions to the plan for six months, so you would lose out on collecting any of your employer's matching contributions during that time. 

But under the new rules, which took effect in 2019 (and assuming your employer's plan has been updated to allow it), you are now able to withdraw your employers' contributions plus any investment gains, in addition to your contributions. You're also allowed to continue to keep contributing, which means you won't fall behind as much on your retirement savings and you still be able to receive your employer's matching contributions. You are also not required to take a plan loan before you take a hardship withdrawal. 

Remember, taking a hardship withdrawal from your employer's retirement plan is really a last resort – the tax consequences are painful, the requirements are strict and cumbersome, and the reduction in your future retirement savings can be sizable. Also remember that even though the IRS provides for employers to allow for hardship withdrawals in their retirement plans, employers can choose not to offer them.

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