During immediate financial emergencies where other financial sources are challenging to leverage, hardship withdrawals from IRAs and 401(k)s can be a worthwhile option. Still, these have specific requirements you need to meet to leverage them without incurring a penalty or tax. This guide explores what qualifies for a hardship withdrawal, the process for approving it and additional financial planning strategies to help you cope financially during a hardship.
What Is a Hardship Withdrawal?
A hardship withdrawal is defined as an emergency withdrawal of retirement funds from a retirement plan. This type of distribution can be allowed without penalty from retirement savings vehicles like Traditional IRAs or 401(k)s, given that specific requirements are met. It’s important to note that even if all criteria are met on behalf of the plan’s owner, they still might incur standard income taxes.
What Qualifies for a Hardship Withdrawal From an IRA?
The Internal Revenue Service (IRS) created eligibility criteria for what qualifies as an immediate and heavy financial need or hardship. Here are the IRA hardship withdrawal rules about which financial hardships qualify for hardship withdrawals.
Medical
Within the IRA rules, there’s an IRS-mandated condition that a 10% penalty will be taken from the distributed funds if taken before age 59½. Suppose the IRA holder does not have health insurance or has medical expenses that are more than their insurance will cover for the year. In that case, they might be allowed to take penalty-free distributions from their IRA to cover these expenses. Note that only the cost difference between these expenses and 7.5% of the IRA owner’s adjusted gross income (AGI) is considered eligible.
Unemployment
If the IRA owner is unemployed, they’re permitted to take penalty-free distributions to pay for medical insurance. To qualify for this benefit, they must have involuntarily lost their employment. The IRA holder must have received the distributions that same year or the year after receiving unemployment compensation and no later than 60 days after getting another job. Additionally, the bills must be significant — representing at least 10% of their AGI — and not covered by any health insurance.
Disability or Higher Education
The IRS allows for early, penalty-free withdrawals from IRAs for other reasons that may or may not be prompted by hardship. These include having a mental or physical disability or needing funds to pay higher education bills for the owner, spouse, children, or grandchildren.
Hardship Withdrawals From 401(k)
Whether or not one is eligible for an early distribution due to hardships or other reasons is entirely up to the 401(k) plan’s sponsor, either through employment or self-employment. The IRS states that “A retirement plan may, but is not required to, provide for hardship distributions.” It is solely up to the provider to specify the criteria that define a hardship. They may ask for information and documentation of said hardship.
If 401(k) plan withdrawals are permitted, the IRS governs whether or not the 10% penalty for withdrawals made before age 59½ will be waived, as well as how much is allowed for withdrawal.
Medical insurance premiums cannot be made through 401(k) funds as they can with IRA funds. Withdrawals to pay for education or expenses for purchasing a first home (free of penalties) are not permitted within a 401(k) but are both allowed at a penalty-free rate for IRAs.
Process for Approving Hardship Withdrawals
Hardship withdrawals from an IRA or 401(k) require you to follow a five-step process to help ensure a smooth approval when you meet all the requirements. Here are the steps for submitting a hardship withdrawal application.
1. Have a Thorough Understanding of Which Hardships Qualify
First, you must understand whether the IRS might allow your hardship to qualify. Here is a simple list of hardship withdrawals allowed for IRAs and 401(k)s:
- Birth or adoption of a child
- Financial emergencies related to unforeseeable or immediate financial needs for family or personal emergencies
- Substantially equal periodic payments (SEPPs), which may incur 10% additional tax
- Certain military reservists who are called to active duty
In contrast, these are the allowed hardship withdrawals only available to IRA, SIMPLE IRA, SEP and SARSEP plans:
- Medical expenses
- First-time home purchase
- Higher education expenses
- Health insurance premiums while unemployed
2. Choose an Appropriate Amount Within the Limits
You may only withdraw as much as is needed for your financial hardship or up to a certain amount as defined by your plan. Before applying for a hardship withdrawal, carefully check how much you’ll be allowed to access according to IRS and plan rules without triggering additional taxes or a penalty. Based on this number, you may plan how you will use the money or if it may be necessary to consider alternative options.
3. Check Your Provider’s Eligibility Criteria
While you may qualify for a hardship withdrawal according to IRS rules, it’s equally important to check your plan provider’s criteria for hardship distributions. For example, your employer’s plan may include funeral and medical expenses as hardships reasons, while principal residence and education expenses are excluded. It’s also important to check whether you’ll still need to pay the 10% bonus penalty even if you qualify for a hardship withdrawal.
4. Provide Proof of Your Hardship
According to the IRS, employers may allow employees to pursue a hardship withdrawal if they can demonstrate that they are experiencing an immediate and heavy financial need that may be challenging to relieve from other resources. These may include if they are unable to seek financial relief by liquidation of the employee’s assets, reimbursement or compensation by insurance, borrowing from commercial sources, stopping elective contributions or employee contributions under the plan or by using other currently available plan distributions maintained by the employer or another employer.
For this reason, it may help to submit relevant documentation, such as bills, invoices and legal documents, with your application to prove that you meet qualifications.
5. Wait for Approval From the IRS
Once you have the relevant documents and know that you have a potentially eligible hardship and amount limit, you may submit a request for a hardship withdrawal to your plan provider. The IRS will review your application and notify you whether it has been approved or if you need to provide additional information.
Financial Planning Strategies During Hardships
Whether you’re experiencing a hardship or creating plans for handling potential hardships in the future, it helps to consider different financial planning strategies to help you stay financially secure in addition to or without using a hardship withdrawal. Here are five strategies you could implement.
1. Emergency Funds
An emergency fund instead of a hardship distribution can be a better solution if financial emergencies or unplanned expenses come up. An emergency fund is typically a cash reserve built from monthly contributions in case an emergency occurs.
If you already have one, you may be able to use it instead of making a hardship withdrawal or in addition to your hardship withdrawal if your plan’s limit is less than the amount you need. If you have yet to build an emergency fund, you can create one by setting a savings goal and making consistent contributions.
2. Hardship Loans
Rather than doing a hardship withdrawal, you might opt for a hardship loan. While you cannot take a hardship loan from your IRA, you can take a loan from a 401(k).
A 401(k) loan may be an ideal option if your hardship does not cost much or if the hardship does not qualify as a heavy financial need to the IRS. If your plan sponsor allows loans, you may borrow $50,000 or 50% of your vested amount, whichever is lower. You have to pay interest, but that goes back into your retirement account, and you avoid paying taxes and penalties as you would with an early distribution.
Other alternative loans to try might include home equity loans or lines of credit for home-related hardships or other low-interest loan options for lower-cost hardships.
3. Minimize Monthly Bills
Review your recurring monthly expenses, subscriptions and services. You may find that you rarely use some purchases and subscriptions, like streaming apps. Try canceling these services to reduce your spending and switching to cheaper products and services for necessary monthly expenses. You may also cut back on expenses by avoiding unnecessary shopping and dining out and trimming utility bills.
4. Maximize Noncash Assets
Another helpful strategy involves taking stock of what you have around the house and maximizing its value. For example, if you have extra toiletry goods like soap, toothpaste and toilet paper for the month, you could create a plan to preserve them and skip buying them for the upcoming month. You may also lower your grocery bills by creating a meal plan to make your current food items last longer.
Lastly, you’ll want to check whether you have gift cards or unused items you could sell or use gift cards and credit card rewards for entertainment and meals.
5. Adjust Retirement Contributions
To reduce the money going out each month, you may want to lower your retirement contributions. This adjustment will allow you to reallocate some funds for a short period until your hardship becomes more manageable.
Learn About Your Hardship Withdrawal Options With Accuplan Benefits Services
IRA hardship withdrawals exist to help you through financially challenging situations. If you have explored all other options, our experts at Accuplan Benefits Services are available to help you understand IRS rules regarding hardship distributions from an IRA or 401(k). Our experienced team of professionals has vast industry knowledge of IRS rules and retirement accounts to provide personalized advice that allows you to follow the rules and avoid penalties. To learn more about your IRA hardship withdrawal options with Accuplan, contact our experienced team today.
Our information shouldn’t be relied upon for investment advice but simply for information and educational purposes only. It is not intended to provide, nor should it be relied upon for accounting, legal, tax or investment advice.