Hardship Withdrawal vs. 401(k) Loan: What’s the Difference?

Hardship Withdrawal vs. 401(k) Loan: An Overview Is it ever OK to borrow from your 401(k) plan, either as a 401(k) loan or a hardship withdrawal? After all, your plan is a powerful retirement savings tool and should be carefully husbanded. Indeed, data from Fidelity shows that the average account balance has climbed to $103,700, as of March 2019. The primary advantage of saving in a 401(k) is the ability to enjoy tax-deferred growth on your investments. When you’re setting aside cash for the long term, a hands-off approach is usually best. Nevertheless, there are some scenarios in which taking money out of your 401(k) can make sense. Before you pull the trigger, though, it’s important to understand the financial implications of tapping your retirement plan early. There are two basic avenues for taking some money out before reaching retirement age. Hardship Withdrawal One way is to take a hardship withdrawal. The Internal Revenue Service (IRS) specifies that hardship withdrawals are allowed only when there’s an immediate and heavy financial need, and withdrawals are normally limited to the amount required to fill that need. These withdrawals are subject to ordinary income tax and, if you’re under the age of 59½, there is a 10% early withdrawal penalty (except if you're affected by the COVID-19 pandemic; see below.) Also, you generally can’t contribute to your 401(k) for six months afterward. The IRS offers a safe harbor exception allowing someone to automatically meet the heavy-need standard if they are in certain situations. For example, a safe harbor exception is allowed for people who need to take a hardship withdrawal to cover medical expenses for themselves, a spouse, or dependents. If you find yourself in a life-or-death medical situation—say, one requiring emergency surgery—taking a hardship withdrawal could help to cover the gap if your insurance coverage falls short. A hardship withdrawal could also be useful if you experience an extended period of unemployment and don’t have an emergency fund to fall back on. The IRS waives the penalty if you’re unemployed and need to purchase health insurance, although you’d still owe taxes on what you withdraw. Other situations that are covered by the safe harbor exception include: - Tuition, related educational fees, and room-and-board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary. - Payments are necessary to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage on that residence. - Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary. - Certain expenses to repair damage to the employee’s principal residence.2 Special COVID-19 Hardship Withdrawal for 2020 If you qualify for a Coronavirus-Related Distribution (CRD) from your 401(k) plan during calendar year 2020, that distribution will be treated as a safe-harbor distribution not subject to a 10% early withdrawal penalty if you are under 59½ but subject to regular income taxes. Additional unique stipulations to this special distribution provide that: - You can withdraw up to $100,000 or your account balance, whichever is smaller. - You can spread out any taxes due over three years. - If you pay the funds back into your account within three years, it will be considered a rollover and not subject to taxes. 401(k) Loan If you’re not in dire financial straits but still want to take cash from your plan, a 401(k) loan is the other option. Under IRS guidelines, you can borrow 50% of your vested account balance or $50,000, whichever is less. A loan, however, has both pros and cons. For example, a loan is just that—a loan, not a distribution. You’re essentially paying back the money to yourself, which means you’re putting it back into your retirement account, and that’s a positive. Loans are usually repaid with interest, which can make up somewhat for the earnings you’re losing by not leaving the money in your plan. The downside is that if you leave your job and don't repay the loan within a specified period (just extended to the due date of your federal income tax return, instead of the previous 60-to-90 day window, under the Tax Cuts and Jobs Act), it’s treated as a regular distribution. In that case, the income tax and early withdrawal penalty would apply. So when is it wise to use a loan? There are situations in which you might consider it. New rules also allow you to take out a loan of up to $100,000 or the amount in your employer-sponsored retirement plan (whichever is smaller) anytime between Mar. 27, 2020, and September 27, 2020, and delay payments on the loan for up to one year. (Interest will accrue.) If you already have an an outstanding loan those payments can also be deferred for one year. Consolidating debt You could use a 401(k) loan to consolidate high-interest debt if your credit doesn’t qualify you for a low rate on a personal loan or debt consolidation loan. Comparing how much you’re paying in interest on your credit cards or other debt to the interest rate your 401(k) plan administrator charges can help you decide which is the better deal. Source: investopedia