Hardship Withdrawal

A hardship withdrawal is an emergency removal of funds from a retirement plan, sought in response to what the IRS terms “an immediate and heavy financial need.” This type of special distribution may be allowed without penalty from such plans as a traditional IRA or a 401k, provided the withdrawal meets certain criteria regarding the need for the funds and their amount.

However, even if penalties are waived (notably, the 10% penalty for withdrawals made before age 59½), the withdrawal will still be subject to standard income tax.

If you’re younger than 59½ and suffering financial hardship, you may be able to withdraw funds from your retirement accounts without incurring the usual 10% penalty.

Not all hardships qualify, however, and you’re still responsible for paying income tax on the withdrawal.

Keep in mind that you won’t be able to return the funds to the account if and when your finances improve.

Consider other alternatives to hardship withdrawals, including a Substantially Equal Periodic Payments (SEPP) plan.

Hardship withdrawals can provide needed funds in an emergency—without a credit check—but they should be used very sparingly and only if all other alternatives have been tried or dismissed. By exposing funds held in a tax-sheltered account to income tax, a hardship withdrawal is likely to boost your tax bill for the year. Even more important, it will permanently deprive you of funds targeted for your retirement.

Unlike, say, a loan you take from your 401(k), the funds from a hardship withdrawal cannot be returned to the account if and when your financial position improves.

Because of these disadvantages, consider a hardship withdrawal only as a last resort to meet an exceptional and pressing need. Indeed, the IRS and most employers who offer 401(k)s impose stringent criteria for these distributions to limit when they may be used and their amount.

The rules that govern such withdrawals, and who administers them, differ by the type of retirement fund.

The IRS will waive the 10% penalty for IRA withdrawals made before age 59½ that are prompted by medically related hardship. If you do not have health insurance or your medical expenses are more than your insurance will cover for the year, you may be able to take penalty-free distributions from your IRA to cover these expenses—or at least some of them. Only the cost difference between these expenses and 7.5% of your adjusted gross income (AGI) is eligible. If you are unemployed, you are permitted to take penalty-free distributions to pay for your medical insurance.

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