A hardship withdrawal is an option in some 401(k) plans that allows participants to take money out of their retirement plan in case of financial hardship. The rules are strict, and the events that qualify for a hardship withdrawal are limited. Withdrawals are taxed as income and subject to a 10% penalty. Participants are also prohibited from contributing to the plan for at least six months after receiving the withdrawal.
A hardship withdrawal is a type of withdrawal option in some 401(k) plans. As the name implies, if there is certain financial hardship 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. Options for taking money out of a retirement plan are limited; 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 withdraw money for financial issues.
The rules governing hardship withdrawals are generally exhaustive and strict. When 401(k) plans do include a hardship withdrawal feature, they will follow the Facts and Circumstances or Harbor Safe set of rules. Safe Harbor rules require that a participant must meet specific criteria to qualify for a hardship withdrawal. The criteria include an immediate and heavy financial need related to six specific events.
One is to pay for the participant’s or dependent’s health care expenses. Another is to pay for the funeral expenses of a deceased parent, spouse, child, or other dependents.
The next three events that could qualify for a hardship withdrawal are related to homeownership. The first is for costs related to the purchase of a primary residence. The following is for amounts needed to avoid being evicted from a principal residence or foreclosure of the mortgage on your principal residence. The third is to pay the expenses for the repair of damages derived from certain disasters such as Hurricane Katrina. The last event that could qualify for a hardship withdrawal is paying for post-secondary education for the participant, their spouse, or their dependent.
In addition to these rules, a participant who makes a hardship withdrawal is prohibited from contributing to the plan for at least six months after receiving the withdrawal. The main reason for this is to discourage the participant from taking the withdrawal. Not only will it be more difficult for the participant to reduce taxable income, but any employer matching contribution for that period will also be lost. Due to the ramifications of not being able to contribute for several months, a participant may look elsewhere for money.
Facts and circumstances rules are less well defined than safe harbor rules. Rather than resort to specific events as described by the IRS, employers must determine whether the participant has incurred financial hardship. In addition, employers must review all relevant facts and circumstances to determine if 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. Also, many 401(k) plan providers will charge a fee to process the withdrawal. Therefore, a hardship withdrawal should only be considered as a last resort.
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