Can You Take a Hardship Distribution From a 401(k)?

by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

May 16, 2012

Dear Carrie,

I'm 57 years old and unemployed. I have $250,000 in a 401(k). Can I withdraw some of the money under hardship?

—A Reader

 

Dear Reader,

Carrie Schwab-Pomerantz.

While it sounds like you're experiencing a tough time, your age and the size of your 401(k) mean that you do have some options for getting though it. If you were employed, my first recommendation would be a 401(k) loan. That way you could access some of your assets without paying income taxes and a possible penalty on your distribution. Unfortunately, a 401(k) loan isn't allowed once you leave a company.

As you suggest, a hardship distribution is another possibility, although what's considered a hardship is very specific—and the cost in taxes and penalties can be formidable. Fortunately, there are other alternatives for someone in your situation.

Look into separation of service
You don't say when your employment status changed, but if you left or lost your job in the year you turned 55 (or later), you could consider a distribution from your 401(k) under what's called separation of service. This allows you to take an early distribution without paying a penalty, although you will have to pay income taxes on it. 

Consider taking Substantially Equal Periodic Payments
If you left your company before age 55, you can still set up a schedule of "substantially equal periodic payments" and avoid the 10 percent penalty. Determined by your life expectancy and an interest rate approved by the IRS, withdrawals must be taken for a minimum of 5 years or until you reach age 59½, whichever is longer. So if you started taking them now at 57, you'd have to continue until age 62. After that, you could take unlimited amounts from your 401(k) penalty-free.

Think about a rollover IRA
Another alternative is to roll over your 401(k) into an IRA. This could actually mean more investment choices and lower fees. Rolling over can be a fairly simple, no-cost process, but you must be sure to roll your 401(k) directly from your employer to your IRA. If you take possession of the money, timing rules and possible penalties come into play. And the IRS also allows you to take a distribution from an IRA in substantially equal payments with no penalty at any age.

Decide what to do if you have company stock
If you have appreciated company stock in your 401(k), there's another possible course of action. You don't have to roll this stock over into an IRA and pay ordinary income tax rates when you withdraw it. Rather, you could transfer the stock to a taxable account and take advantage of what's called net unrealized appreciation. With this strategy, you generally pay taxes only on the cost basis of the company stock (its value when you received it), which could be significantly lower than the current value. Then when you sell, you pay long-term capital gains taxes, not ordinary income taxes.

Consider a hardship distribution a last resort
Qualifying for a hardship distribution from your 401(k) isn't easy. First, you must prove what the IRS considers "immediate and heavy financial need." In general, the IRS defines this as:

• Medical expenses for you, your spouse or dependents
• Costs directly related to the purchase of your principal residence (excluding mortgage payments)
• Post secondary tuition and related educational fees, including room and board for you, your spouse or dependents
• Payments necessary to prevent you from being foreclosed on or evicted from your principal residence
• Funeral expenses
• Certain expenses relating to the repair of damage to your principal residence

The amount of the distribution is limited to your own contributions to the plan and possibly your employer's contributions but doesn't include earnings or income on your savings. It also can't be for more than the amount of the specific need—and you can't have other resources available to cover it.

Another big negative is that even if you qualify for a hardship distribution, you'll have to pay both income taxes and a 10 percent penalty. To me, this like rubbing salt in your wounds!

And finally, another possible snag is that while the IRS allows hardship distributions, not all plans do. Some only allow them under very limited circumstances, for instance to prevent a foreclosure but not for education expenses. Also, a retirement plan isn't required to allow such distributions once you're no longer working for the company.

Get specific tax advice
My main concern for anyone who wants to tap into retirement assets early is how it will affect financial security later on. Remember, you're not only depleting your hard-earned savings, you're also losing the potential for tax-deferred growth.

But sometimes, present concerns have to trump future possibilities. If your 401(k) is your only recourse, I strongly urge you to talk to a tax or financial advisor before taking action. Get information specific to your situation—and only withdraw as much as you need to keep yourself afloat until things turn around.

 

Important Disclosures
The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.