Cashing Out My 401(k) – Loans vs. Hardship Withdrawals – Which is The Better Option?

With rising prices and economic uncertainty, many Americans are still finding it hard to make ends meet and find that they are having to tap one of their most important and final saving vehicles – their company sponsored 401k or 403b (tax advantaged) retirement plans.

There are 3 ways that cash can be taken out from a 401K account: A regular 401k loan, hardship or non-financial hardship withdrawal. Each is explained below with the applicable provisions.

401(k) Loan

The primary benefits of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default and no credit check is required to qualify.

It is up to your employer and plan administrator (like Vanguard, Fidelity for larger corporate plans) to determine the minimum (normally $1,000) and maximum (up to 50% of balance) loan amounts. The government does not set guidelines or restrictions on the uses for 401k loans.

The 401k loan must be paid back over the subsequent five years with the exception of home purchases, which are eligible for a longer time horizon. If you are married, your spouse will need to consent to the loan as well.

401k Loan Interest Expense

Even though you’re borrowing from yourself, you still have to pay interest on the loan amount. Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit to your retirement account is that you will eventually get this money back in the form of qualified disbursements at or near retirement, and the interest you pay back into your 401k plan is tax-deductible.

The biggest disadvantage of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results.

Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.

Hardship withdrawal

If you cannot take out a 401k loan, you may still be able to get a hardship withdrawal from your plan. Many 401k plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs, but the IRS has strict guidelines as to what the funds can be used for.

To qualify for a hardship withdrawal, you must demonstrate (with supporting evidence) to your plan’s administrator that the withdrawal is necessary due to an immediate and severe financial need which cannot be funded elsewhere.

You must also confirm that the loan does not exceed the amount of the need (i.e. cannot borrow extra) and you have already obtained all distributable or non-taxable loans available under your 401k plan. If these conditions are met, the funds can be withdrawn and used for one of the following purposes (per the IRS).

– Cost for buying a house that is you primary residence. Mortgage and ongoing payments are not covered.

– Necessary medical care expenses or Education fees for yourself, spouse and immediate dependents.

– Payments necessary to prevent eviction or foreclosure on the mortgage of your primary residence.

– Burial or funeral expenses

All 401k hardship withdrawals are still subject to taxes. This means that a $10,000 withdrawal can result in not only significantly less cash in your pocket (possibly as little as $6,500 or $7,500 if you are in a high income tax bracket), but causes you to forgo forever the tax-deferred growth that could have been generated by those assets.

401k hardship withdrawal proceeds cannot be returned to the account once the disbursement has been made, and in most cases you’re not permitted to contribute to your plan for six months after the withdrawal. The IRS also requires that the amount withdrawn be reported as gross income.

Non-Financial Hardship 401k Withdrawal

Although the investor must still pay taxes on non-financial hardship withdrawals, the ten-percent penalty fee is waived. There are five ways to qualify:

1. You become totally and permanently disabled

2. Your medical debts exceed 7.5 percent of your adjusted gross income

3. A court of law has ordered you to give the funds to your divorced spouse, a child, or a dependent

4. You are permanently laid off, terminated, quit, or retire early in the same year you turn 55 or later

5. You are permanently laid off, terminated, quit, or retired and have established a payment schedule of regular withdrawals in equal amounts of the rest of your expected natural life. Once the first withdrawal has been made, the investor is required to continue taking them for five years or until he/she reaches the age of 59 1/2, whichever is longer.

If you do need money from your 401K account, then a loan is preferable to a 401k hardship withdrawal because you start paying it straight back and incurs no penalties.

As soon as your financial situation is more stable you should start contributing back into your 401K plan, which is the most tax efficient investment over the long term.

Remember, your 401k is meant to provide retirement income, and should be a last-resort source of cash for expenses before then.

You can also withdraw funds early from an IRA and in many cases is more cost effective. For example, an IRA has a lifetime withdrawal exemption of $10,000 for a house with no strings attached.

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2 thoughts on “Cashing Out My 401(k) – Loans vs. Hardship Withdrawals – Which is The Better Option?”

  1. Creative discussion – I was fascinated by the analysis – Does someone know if my business might get a sample IRS 12277 form to fill out ?


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