A hardship withdrawal is a distribution from a 401(k) plan to be “made on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need,” according to the IRS. Retirement plans are not required to offer hardship withdrawals. Among plans that permit them, some employers require the employee to provide paperwork proving the amount of the hardship. Below are the expenses the IRS stipulates fall under the hardship withdrawal designation.
1. Prevent eviction or foreclosure of your primary residence:
- Eligible expenses: all expenses tied to preventing the eviction or foreclosure, except attorney fees
- Documentation, if required: an eviction notice, notice of foreclosure, notice to vacate the premises or a signed letter from the landlord; statement must be dated within the last 60 days, and it must be clear that eviction or foreclosure will result without payment
2. Purchase of a primary residence:
- Eligible expenses: costs directly related to the purchase or construction of a primary residence, including building materials and closing costs
- Documentation, if required: a copy of estimated settlement costs, a good faith estimate or sales contract; if building a home, a government issued building permit might be acceptable
3. Post-secondary education expenses for the next 12 months for you, your spouse, dependents or your children:
- Eligible expenses: tuition, lab fees, technology fees and room-and-board provided by the school; student loan payments are not covered, nor are non-tuition related expenses like books, bus fare or academic club fees
- Documentation, if required: copy of applicable bill
4. Funeral expenses:
- Eligible expenses: all fees associated with the service, burial or cremation
- Documentation, if required: invoices from funeral home, cemetery and/or religious institution
5. Medical expenses not covered by insurance for you, your spouse or dependents:
- Eligible expenses: treatment by licensed medical professional, hospital treatment, prescription drugs and some dental procedures
- Documentation, if required: medical bills or estimates for expenses not covered by insurance; insurance statement indicating the expenses not covered
6. Expenses to repair damage or to make improvements to your primary residence:
- Eligible expenses: any expense associated with repairing your primary residence that is not covered by homeowners insurance
- Documentation, if required: estimate or invoice from the company repairing the residence; It is important to note that expenses already paid are not covered
Even though these are the legal parameters for a hardship withdrawal, they are intended to be an option when no other options are available. The IRS does not recommend or endorse these withdrawals. In fact there are generally heavy penalties for hardship withdrawals. The hardship withdrawal will be subject to income taxes and a 10% penalty if you’re under the age of 59 ½. Because the withdrawal will be considered earned income, the recipient’s taxable income will increase, which could result in a tax-bracket increase.
Since taxes are deducted at the time of the hardship withdrawal, it is necessary to withdraw the amount needed plus taxes. This is called “grossing-up.” For example, if the hardship is $1,000 and 20% is withheld, the recipient would get $800. In order to receive $1,000, it would be necessary to withdraw $1,250.
Employers can require employees to exhaust all other options before taking a hardship withdrawal, including loans and in-service withdrawals. The maximum hardship withdrawal will be the lesser of:
- the (grossed-up) amount needed to cover the hardship expenses or
- the amount of your elective contributions.
Generally withdrawals cannot be taken on earnings, non-elective contributions or matching contributions. In plain terms, what you put in is what you can take out.
Typically plans do not allow an employee to make contributions to the retirement plan for the six months after taking a hardship withdrawal. This means missing out on potential matching contributions. Any unused hardship money cannot be replaced into the 401(k) plan or rolled into any other retirement plan, like an IRA.