Bil Sadler Talks About How to Take a Hardship Withdrawal from a 401(k)
Thursday, November 15th, 2012
There's no question the past five years have been some of the toughest economic times since the Great Depression.
Many people have been out of work, and some for prolonged periods. If work has been found, it's possible for lesser pay. An extended economic slowdown, such as this, eventually can take its toll on more and more people, including the affluent.
In my mind, the real question is: When will it get better? Will we ever see a robust economy like the 1980s and 1990s? What can we do to bridge the gap?
People are resourceful. We search for answers. We do what it takes to tow the line. Yet sometimes, perhaps beyond our control, we simply can't make ends meet.
One possibility for those with a 401(k) plan is the hardship distribution. The hardship distribution is a special provision in the Tax Code to allow a participant to take a distribution due to financial hardship. Even though the Tax Code may allow for hardship distributions, the 401(k) plan document must also allow for such distribution.
What constitutes a hardship? The IRS provides a list of expenses that generally qualify as hardship withdrawals:
- medical expenses for you, your spouse, or your dependents
- expenses to purchase a principal residence
- post-secondary education expenses including tuition, room and board, and related educational fees for you, your spouse, children, or dependents
- expenses to prevent eviction from, or foreclosure of, your principal residence
Having an expense that falls into one of these categories does not guarantee qualification for a hardship withdrawal. Besides allowing for hardship distributions, the 401(k) plan must provide an objective method for determining the extent of the hardship as well as measuring the amount of money necessary to meet the need. Typically, the employer shoulders this responsibility.
Next, assuming the financial need is immediate and heavy, you must also have exhausted all other available resources. For example, if a loan is available from your 401(k), you must pursue the loan first.
The basic idea is that withdrawing funds from your retirement plan should be the absolute last resort. After all, retirement plans were set up through the Tax Code to provide for retirement. Unfortunately, due to unforeseen circumstances, the retirement plan can be a source of emergency dollars.
What does it mean to qualify? If you qualify, after jumping through the hoops described above, you simply gain access to your funds without jeopardizing the plan's tax status. Who cares, you ask? Your employer and all the other participants! This is why the plan must establish a method for qualifying the financial need.
So what's in it for you? You gain access to your retirement funds; however, the hardship distribution is a taxable event. Therefore, you will receive a 1099-R, which is also provided to the IRS, indicating the amount of the withdrawal. Use the 1099-R to report the distribution on your tax return.
If you are under 59 1/2, the distribution is also considered an early withdrawal and is subject to the 10 percent early withdrawal penalty, unless it qualifies for one of the many exceptions.
How much is the tax? Your employer is required to withhold 20 percent from your distribution. However, your actual tax liability depends on your tax bracket for the year of the distribution. For example, assume you request a $10,000 hardship distribution. Your employer is required to withhold 20 percent, therefore, you'll receive a check for $8,000. When you file your tax return, you'll report a distribution of $10,000. If you're in a 10 percent tax bracket, then the tax liability related to this distribution would be $1,000. In this example, since $2,000 was withheld and the actual tax was only $1,000, then you could get a refund for the additional amount withheld or receive credit against other taxes you may owe.
Taking money from a retirement plan, particularly prior to 59 1/2, is an expensive alternative. For example, if someone is in the 15 percent tax bracket for Federal income tax, the potential taxes could be as high as 31 percent, consisting of 15 percent for Federal income tax, 10 percent early withdrawal penalty, and 6 percent State income tax (assuming Georgia). If the taxpayer is in the 25 percent Federal tax bracket, the total increases to 41 percent. Therefore, a $10,000 distribution could cost $3,100 to $4,100. Of course, it could be more or less depending on the taxpayer's tax situation.
The hardship provision can be a tremendous source of financial relief. Before taking a hardship distribution, consider all possible resources and consult with a tax professional to determine how the distribution would impact your tax liability.
Taking a distribution may solve a problem now, but could create a new one at tax time. That doesn't mean you shouldn't take a hardship distribution, it simply means you should be aware of the consequences.
Disclosure: Bil Sadler, CFA, CPA, CFP®,Securities offered through H.D. Vest Investment ServicesSM, Member SIPC, Advisory services offered through H.D. Vest Advisory ServicesSM , 2531-C Lafayette Plaza Dr., Albany, GA 31707. The views and opinions presented in this article are those of Bil Sadler and not of H.D. Vest Financial Services® or its subsidiaries.