Save 401(k) hardship withdrawals for true emergencies

Weigh other choices before robbing your own retirement

Question for the expert

Dear New Frugal You,
I am trying to make a hardship withdrawal from my company's 401(k) program. The administrator has asked me for proof of the hardship. I have read their company 401(k) booklet and it does not mention this in the program guidelines. I am fully vested. Is this not my money and are they required by law to give me the money with or without proof? Thanks -- Mark

Answer for the expert

Dear Mark,
In a word, yes, it is your money. And you do have some withdrawal privileges. But, you also gave away some control when you took advantage of the tax savings you received because of your contributions.

You should be able to withdraw any amount that you have contributed. However, you will be prevented from withdrawing earnings on the amount you contributed or the amount contributed by your employer -- at least on a hardship distribution. For more info, check the IRS FAQ on 401(k) plans.

In fact, a 401(k) plan does not have to allow for hardship distributions. The plans that do, such as your employer's, are required to verify your hardship prior to withdrawal. The guidelines have to be spelled out in fairly specific terms. Your plan administrator should be able to send you a list of what qualifies for hardship. Typical expenses that qualify are medical costs, purchasing or rehabbing a primary residence and educational expenses.

The employer (or plan administrator) is supposed to make it tough to take a hardship withdrawal. Money in a 401(k) plan is meant for your retirement. Any hardship or early distribution will reduce the balance in your 401(k) account. Naturally that will mean fewer dollars for you when you get to retirement.

So before you head down to your HR department and demand your money, you might want to make sure the hardship withdrawal is your best option.

Suppose that you do take a hardship withdrawal and you're in the 28 percent federal tax bracket. For every $1 withdrawn, you'll pay 28 cents in taxes and 10 cents in early withdrawal penalty, plus any state or local income taxes due. So, at best, you'll end up with 62 cents per $1 withdrawal. That's a pretty steep price to get your money.

You may find that there are other ways to get the cash you need. For instance, you may want to consider a 401(k) loan or IRA penalty-free withdrawal. You can find out more at the IRS site.

Either a 401(k) loan or IRA penalty-free distribution will allow you to keep all the money you withdraw. No portion will go to our friends at the IRS. Plus, in the case of a 401(k) loan, once you've repaid the loan, the money will be compounding without the drag of taxes. So you'll be in a much better position at retirement.

One thing that you cannot do is use your 401(k) balance as collateral for a bank loan. That will be considered the same as a taxable distribution.

A 401(k) hardship distribution should be just that: It should only be taken as a last resort when no other source of funds is available and a hardship will result from not getting the money.

See related: Don't use 401(k) to pay off credit card

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Updated: 03-23-2019