Have you considered taking money out of your 401k savings in the last year to cover credit card debt, financial emergencies, or daily expenses?
While taking money out of your retirement fund before you are eligible often comes with financial penalties, the number of Americans making hardship withdrawals from their 401k plans is on the rise during a time when credit card debt, interest rates, and inflation are making it difficult for the average consumer to save money, let alone pay off debts and handle financial emergencies.
Nearly 3 percent of American employees made hardship withdrawals from their defined 401k contribution plan in 2022, an increase from 2.1 percent in 2021, according to Vanguard’s How America Saves 2023 report.
“Hardship withdrawals increased moderately, perhaps signaling that some households were facing financial stress,” the Vanguard report said. “We are starting to see signs of financial distress at the household level,” added Fiona Greig, global head of investor research and policy at Vanguard.
However, the report noted that the overall “modest increase in hardship withdrawals is not entirely surprising.
“It is important to note that more than 97 percent of participants did not take a hardship withdrawal during this challenging year. This data underscores that participants are generally resilient and maintain a long-term approach to retirement savings, even during uncertain economic times,” the report continued.
While Vanguard’s report was optimistic about the increase in the number of Americans tapping into their 401ks for hardship withdrawals, a 2022 study from Empower, a large retirement plan administrator, found that 401k hardship withdrawals increased by 24 percent. According to the study, the funds were predominantly used to cover unexpected financial burdens.
“Their budgets are stretched thin,” said Luis Fleites, the director of thought leadership at Empower Retirement, about American consumers.
“People are feeling the pinch from inflation,” said Philip Chao, principal and chief investment officer at Experiential Wealth in Cabin John, Maryland.
Financial services firm Fidelity similarly saw a rise in 401k participants taking hardship withdrawals from their accounts, with 2.4 percent of workers making withdrawals compared to 1.9 percent in 2021. Fidelity noted that this is the highest number of hardship withdrawals the company has recorded, adding that the firm typically sees 2 to 2.3 percent of hardship withdrawals annually.
“Many people cannot keep up with the costs of living,” says Mark Kinsella, a financial planner at Family Financial Planning Services in Wheaton, Illinois. “The retirement plan may be the only cushion available.”
Two of the most common reasons for withdrawing money from one’s 401k were to pay for medical emergencies or to prevent eviction by ensuring one could afford rent or mortgage payments.
“One’s health insurance may not cover a particular health issue,” Kinsella says. If you or someone in your family needs treatment or major surgery, you might tap into retirement funds to help. Emergencies such as a job loss or a natural disaster could also lead account owners to access funds early.
Remind Me, What is a 401k?
A 401k is an employer-sponsored retirement account that allows employees to contribute a portion of their salary before Internal Revenue Service (IRS) tax withholding also known as tax-deferred. Companies often will match a percentage of the employee’s contribution and add it to their 401k account.
Because a 401k account is designed to be used during retirement, withdrawing money from a 401k account before you are age 59½ means you’ll encounter some financial penalties, in addition to having to pay taxes when you take funds from the account.
One of the reasons you may choose to withdraw money early is due to financial hardship. According to the IRS, a hardship withdrawal is when a participant has an “immediate and heavy financial need,” and there is no alternative source to obtain money from.
When a hardship withdrawal is taken, you’ll often be required to pay a 10 percent withdrawal fee if you are not yet 59½. You’ll also need to pay taxes on the withdrawal amount, and if you are within a certain income tax bracket, that money is considered to be part of your income. In other words, you may end up paying 32 percent tax on your withdrawal.
For example, if you withdraw $10,000, you will only net $6,800 after paying a 32 percent tax. If you need the full $10,000, you’ll have to withdraw a larger amount, around $14,706, in order to ensure you retain enough of your money.
Not all employers allow hardship withdrawals. Those that do often have certain requirements that must be met, says Kevin Chancellor, a financial planner and founder of Black Lab Financial Services in Melbourne, Florida.
Eligible reasons for a 401k hardship withdrawal include:
- Funds to purchase a principal residence.
- High medical expenses.
- Qualifying tuition and education-related fees.
- Preventative measures to avoid a foreclosure or home eviction.
- Burial or funeral expenses that qualify.
- Disaster-related repairs.
Jeanne Sutton, a certified financial planner with Strategic Retirement Partners in Nashville, said that in her experience, the top reasons for hardship withdrawals are medical debt and the purchase of a new home. “Most of the time, they don’t have options that are better,” Sutton said. People with large medical bills should try to negotiate a medical debt repayment plan before tapping retirement funds, she said.
There are some exceptions to the 10 percent early withdrawal tax. The early penalty can be avoided if the withdrawal is used for:
- Unreimbursed Medical Expenses
- Health Insurance Premiums
- Permanent Disability
- To fulfill an IRS Levy
- You’re called to Active Military Duty
If you do have a need to withdraw money from your 401k account due to financial hardship, you’ll need to provide adequate documentation as proof of your hardship withdrawal, such as invoices from a funeral home or university, insurance or hospital bills, bank statements, or escrow payments. This information is not necessarily disclosed to your employer or your retirement plan sponsor, but it is important to gather proof for tax purposes.
You’ll also be required to prove that you don’t have an alternative source where you can access funds to pay for your financial hardship, such as an emergency savings account, a home equity line of credit, the ability to negotiate affordable payments, or the ability to obtain a personal loan.
Once your hardship withdrawal is approved, the funds will be released to you. However, it’s important to note that most qualified hardship withdrawals from a 401k cannot be repaid, which ultimately affects your retirement savings long-term.
“Taking $30,000 for a hardship withdrawal could cost you over $100,000 over the course of your working career,” Chancellor says due to the loss of compounding money. “Planning early and building an adequate emergency fund can not only save you from a hardship, but also indirectly help your retirement.”
Ted Jenkin, a certified financial planner and co-founder of oXYGen Financial, based in Atlanta, agrees it’s a “terrible idea to take money out of your 401k.”
Not only is your retirement savings affected, but you’ll also have to pay taxes on the amount you withdraw. If your hardship withdrawal request is not deemed qualified and/or if the amount you need to withdraw is larger than what is needed to cover a specific, qualifiable financial hardship, you may also be subject to an early withdrawal penalty.
“While it may look like a low-cost way to borrow, borrowing from your 401(k) is borrowing from your future,” says Jay Zigmont, certified financial planner and founder of Childfree Wealth. “You are taking money out of the market where it can grow. Additionally, if you lose your job, the 401(k) loan will become due, or else it will be seen as a disbursement, including taxes and a penalty.”
Hardship withdrawals should be a “last resort,” said Joni Alt, a senior wealth adviser at Evermay Wealth Management in Arlington, Va. She suggested exploring other alternatives first, like a home equity line of credit.
Jenkin suggested consumers consider canceling or reducing membership plans, selling little-used or unneeded items on Facebook Marketplace or at a garage sale, and even consider a short-term loan instead of withdrawing from their 401k.
Does it Ever Make Financial Sense to Withdraw Early from your 401k?
While most financial advisors recommend using your emergency savings or taking out a personal loan before taking a 401k hardship withdrawal, Carol Hoffman, a principal advisor with Clear Perspectives Financial Planning in Cincinnati, Ohio, says there are some instances in which it makes sense to withdraw funds from a 401k.
Hoffman shared she has a 55-year-old client facing a daunting financial challenge. The client is employed but is leaving her job. Hoffman’s client has a pension where she earns about $6,000 per month and a 401k worth around $60,000. The client’s husband is also employed and has a retirement plan of his own. But the couple incurred “significant debt” sending their three children to college, and they also had around $25,000 in credit card debt.
Because the IRS allows 401k withdrawals at age 55 if someone leaves their job, and her client was 55, Hoffman says she ultimately recommended her client withdraw her full 401k and pay down her debt. But Hoffman says those who withdraw from their 401k need to use extreme caution and examine their financial behavior because once the money is gone, it’s gone.
“People who run up a lot of debt at once tend to do it repeatedly, so we can only recommend this strategy if we are working with them to plan their spending and increase their savings. We cut up their credit cards,” Hoffman said.
“Don’t make it a habit,” Sutton says if you choose to take a 401k early withdrawal.
“Hardship withdrawals from 401(k) plans can make sense at times, but only after all other options have been exhausted,” says William J. Procasky, an assistant professor of finance at Texas A&M University—Kingsville.
Dave Lowell, certified financial planner and founder of Up Your Money Game, agrees, noting that the timing of your early withdrawals is also an important consideration.
“If you were employed for most of the year and had a relatively high income, then it makes sense to not withdraw money under the rule of 55 in that calendar year since it will add to your total income for the year and possibly result in you moving to a higher marginal tax bracket,” Lowell says.
A more financially-savvy strategy may be to use other savings or withdraw from after-tax investment accounts if available until the next calendar year. If you still need to withdraw from your 401k the next calendar year, your taxable income will likely be much lower, and you may not incur as much of a tax penalty.
Another thing to keep in mind is that the IRS recently changed rules regarding 401k withdrawals.
Under the SECURE 2.0 Act of 2022, employees can claim an emergency hardship expense that merits a hardship withdrawal. And beginning in January 2024, employees can withdraw $1,000 per year from their 401k for emergency expenses without incurring the 10 percent early withdrawal penalty. However, you will need to repay the account for the distribution withdrawal before additional funds can be withdrawn.
What if a 401k Withdrawal is Not Available?
Not all employers allow early 401k withdrawals, including for financial hardship. In some cases, an employer might allow a retirement plan loan.
This option could help you avoid paying taxes and penalties on the amount withdrawn.
Most retirement plan loans allow you to borrow up to $50,000 or 50 percent of your vested account on a tax-free basis. You have to repay the loan within five years, sooner if you leave your job.
However, a retirement plan loan is seen as an attractive alternative to a hardship withdrawal for a few reasons:
- You won’t owe taxes on the amount you borrow
- If you repay the loan in a timely manner, you won’t miss out on years of compounding growth in your account.
- The interest payments can be added to your 401k.
“Generally, the interest rate on the loan would be reasonable,” Kinsella says about retirement plan loans. “Repayments of the loan would be deposited back into the employee’s work retirement plan.” The setup allows you to reimburse the account over time. After repaying the loan, you might not have as much as you did before you took out the funds, but you will likely have more than if you merely took a withdrawal.
One thing that may incentivize you to pay back your 401k loan quickly? Most 401k loan plans don’t allow you to contribute to your retirement account while you have an outstanding balance.
Another downside? You’ll be using after-tax income to pay back your retirement loan. And when you take the money out of your 401k in retirement? You’ll have to pay taxes again.
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