401k Hardship Withdrawal Rules
IRS Guidelines for Early Withdrawal During Financial Hardship
Oct 22, 2009
An individual hoping for an early withdrawal of his or her 401(k) plan must meet the qualifications outlined by the IRS Retirement Plan FAQ concerning hardship distributions of retirement funds.
The Definition of Financial Hardship for Early Withdrawal of a 401(k) Retirement Plan
Not all 401k plans provide for early withdrawal due to financial difficulties. In the event that a 401k does allow the plan to be cashed out early in a hardship distribution, the plan will stipulate what situations qualify as hardships. Hardship qualifications vary depending on the 401k plan, but commonly include such situations as:
- Medical expenses
- Purchase of a first home
- Funeral expenses
- College expenses of the employee, employee’s spouse, or employee’s dependents
- Preventing foreclosure
An Employee May Be Required to Provide Proof of Financial Hardship to Gain Access to 401k Funds
Whether or not an employee must prove a financial hardship to be eligible for an early withdrawal based on those criteria depends on the guidelines of the 401k plan. Typically an individual has two options to gain access to his or her 401k funds due to financial difficulties:
- Proof of Need- If a 401k plan requires an employee to prove his or her need for the funds, it will stipulate which documents are required prior to cashing out the plan. Individuals may then continue to contribute to their 401k retirement plans beginning the following pay period.
- Self Certification- Under self-certification, an employee is not required to provide proof to obtain a hardship distribution. An individual opting for self-certification, however, is restricted from contributing to his or her 401k for a period of six months following the distribution of retirement funds.
Penalties for Financial Hardship Distributions
Employees opting to cash out a 401k plan early for any reason will be required to pay taxes on the full amount withdrawn. Depending on an individual’s tax bracket, this can amount to 35-45% of the amount cashed out. The IRS also requires that the amount withdrawn be reported as gross income.
An additional tax on early distribution of elective contributions to retirement funds may be levied against the amount withdrawn, depending on the type of 401k plan.
Limitations on Hardship Distributions
Consumers hoping to cash out a 401k should be aware that, even if a hardship withdrawal is permissible under their retirement plan, there are still limits to how much can be withdrawn. The employee’s financial situation must meet certain criteria such as:
- The funds contained in the 401k plan must be enough to meet the employee’s need
- Funds in excess of the financial need may not be withdrawn under financial hardship.
- The employee must be unable to meet his or her financial need any other way.
- Funds in excess of what the employee contributed may not included in a hardship distribution
If an employer is aware of the fact that an employee attempting to have an early withdrawal approved is in possession of other assets that, when liquidated, would provide the necessary funds to meet the employee’s financial need, he or she may decline to cash out the 401k.
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