There are a few situations where it makes sense to tap your 401(k) to get rid of personal debt. All of them fall into the category of hardship withdrawals, which are designated for “immediate and heavy” financial needs.
In some cases, you might be able to withdraw funds from a 401(k) to pay off debt without incurring extra fees. This is true if you qualify as having an “immediate and heavy financial need,” and meet IRS criteria. In those circumstances, you could take a hardship withdrawal.
If the plan does allow hardship distributions, it must specify the criteria that define a hardship, such as paying for medical or funeral expenses. Your employer will ask for specific information and possibly documentation of your hardship.
The administrator will likely require you to provide evidence of the hardship, such as medical bills or a notice of eviction.
The short answer: It depends. If debt causes daily stress, you may consider drastic debt payoff plans. Knowing that early withdrawal from your 401(k) could cost you in extra taxes and fees, it's important to assess your financial situation and run some calculations first.
Your retirement savings should probably be a last resort to meet your financial needs, for most people. You could incur penalties and taxes to use your retirement savings to pay off debt. Plus, you'll lose out on investment income, which can be impossible to recover in the future.
Lying to get a 401(k) hardship withdrawal can have serious consequences, such as legal repercussions in the form of fraud, financial penalties, and tax implications. If you're caught lying about legibility for a hardship withdrawal, you may face additional fees, fines, and even imprisonment.
Your employer will ask for certain information and possibly documentation of your hardship. If your employer permits a withdrawal for a particular reason, though, IRS rules govern whether or not the 10% penalty for withdrawals made before age 59½ will be waived, as well as how much you're allowed to withdraw.
While the IRS may allow you to make a hardship withdrawal, that doesn't mean you'll escape the 10 percent penalty tax (again, on top of what you'll already pay in taxes on the distribution). Only certain kinds of early withdrawals escape the penalty tax, including the following: Separation from service after age 55.
Permitted Uses for Hardship Withdrawals
The IRS permits 401(k) hardship withdrawals only for “immediate and heavy” financial needs. According to the IRS, the withdrawals that qualify include: Health care expenses for you, your spouse or a dependent. Purchase of a principal residence.
You are in financial hardship if you have difficulty paying your bills and repayments on your loans and debts when they are due.
If your plan allows hardship withdrawals, you may need to prove to your employer or self-certify that you meet your plan's requirements. If your plan doesn't allow hardship withdrawals, you may still be able to make a non-hardship early withdrawal or take out a 401(k) loan.
A hardship letter explains to a lender the circumstances that have made you unable to keep up with your debt payments. The letter provides specific details such as the date the hardship began, the cause and how long you expect it to continue. Many creditors will require a hardship letter if you request help.
While there isn't technically a limit on the number of 401(k) hardship withdrawals you're allowed in a year, you are limited by whether you qualify and whether you have enough money in your 401(k) to cover the qualifying hardship amount.
Section 2022 of the CARES Act allows people to take up to $100,000 out of a retirement plan without incurring the 10% penalty. This includes both workplace plans, like a 401(k) or 403(b), and individual plans, like an IRA. This provision is contingent on the withdrawal being for COVID-related issues.
For example, some 401(k) plans may allow a hardship distribution to pay for your, your spouse's, your dependents' or your primary plan beneficiary's: medical expenses, funeral expenses, or. tuition and related educational expenses.
Hardship withdrawals may get even easier to tap in 2023 with the new Secure 2.0 retirement regulations signed into law by President Biden in December. The new rules allow employees to self-certify that they meet the hardship criteria and will only take out the amount they need to cover their financial emergency.
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.
You can do a 401(k) withdrawal while you're still employed at the company that sponsors your 401(k), but you can only cash out your 401(k) from previous employers.
Hardship distributions are includible in gross income unless they consist of designated Roth contributions. In addition, they may be subject to an additional tax on early distributions of elective contributions.
A hardship withdrawal is when you take money early from your 401(k) account in response to an immediate, urgent financial need. While early withdrawals (those made before you reach the age of 59.5) normally come with a 10% penalty, this penalty does not apply to hardship withdrawals.
Financial Hardship Letter: Example
Situation: Write a brief explanation of your situation and why you're asking for help. Plan of action: Explain what you are requesting from the lender and how you plan to adjust your financial situation so you can continue to make payments in the future.
Permanent hardship means that the income support recipient's financial situation is unlikely to improve in the foreseeable future.