Q. My family is facing an emergency and we need cash. Does it make sense to take a “hardship withdrawal” from my 401(k)?
Hardship withdrawals from 401(k) plans allow you emergency access to your savings under certain narrow circumstances, without having to pay the money back. They are allowed by law, but the rules for what qualifies as a hardship are strict, and employers do not have to allow them.
In order for a withdrawal to qualify under Internal Revenue Service rules, the money must be needed to handle “an immediate and heavy financial need.” Buying a car, for instance, does not qualify.
The kind of expenses the IRS allows include:
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Medical expenses for the employee, the employee's spouse, or dependents.
Costs directly related to buying or repairing major damage to a home, or payments needed to prevent eviction from or foreclosure on the mortgage of the employee's principal residence.
Tuition payments and related expenses for the next 12 months of post-secondary education for the employee or the employee's spouse, children, or dependents.
Funeral expenses for the employee's deceased parent, spouse or other family member.
Even if your use of the money fits one of those definitions, the IRS still expects you to try other ways to pay for your emergency before withdrawing money from your 401(k). That could mean things like tapping insurance policies or selling assets.
“You've got to be able to show what the need is and to show you can't meet the need some other way,” explained Irv Diamond, a principal with REDW Stanley Financial Advisors in Albuquerque, N.M.
Moreover, Diamond noted, if you are under age 59 1/2, you'll have to pay a penalty for early withdrawal, in addition to paying taxes on the money. The IRS allows you to take money to cover the taxes and penalty out as part of the withdrawal, but the total cost is much higher when you consider the lost compounding of earnings.
If you do take a hardship withdrawal, you generally will be prohibited from making new contributions to your plan for at least six months.
The rule that requires using other resources first can lead you to take out a loan from your 401(k), if that option is offered by your plan. Wolohan said a loan is usually a better choice, because it helps maintain the goal of the 401(k), which is retirement.