What’s a 401(k) hardship withdrawal and can I use it to pay off debt?

Life is expensive, even if you're careful about budgeting and make every penny count. A financial emergency or temporary hardship could put you in a tight spot if you don't have cash in a savings account to cover it.  

You might wonder if a 401(k) hardship loan is possible. After all, it's your money, so why not use it to get through a tough situation if you can? Tapping into your retirement could help you get back on solid ground, but there are drawbacks to consider. 

What is a 401(k) hardship withdrawal?

A 401(k) hardship withdrawal is when you use money from your retirement account to cover expenses that you otherwise can't meet. Employers aren't required to allow hardship withdrawals from 401(k) plans, but many do. If your job allows 401(k) withdrawals, the IRS has two requirements:

• The withdrawal must be due to an immediate and heavy financial need.

• It must be limited to the amount required to satisfy that need. 

How do you know if your plan allows hardship withdrawals? Your plan paperwork should tell you, but it might be easier to reach out to your plan sponsor or benefits coordinator to ask about hardship options. 

Now, what if you have a different kind of retirement plan at work that isn't a 401(k)? 

Under IRS rules, any plan that allows employees to make voluntary contributions can offer hardship withdrawals. So, you could still qualify for one if you have a 403(b) or a 457 plan instead. The 403(b) plan is for people who work in public schools, tax-exempt hospitals and charities, and ministers. Local and state governments and some nonprofits offer a 457 plan to their employees.   

What can you use a 401(k) hardship withdrawal for?

The IRS generally allows hardship withdrawals from a 401(k) for three categories of expenses:

• Medical 

• Funeral 

• Tuition and education 

The SECURE 2.0 Act added a provision to allow for small withdrawals in a financial emergency. You can pull up to $1,000 per year from your 401(k) for personal or family expenses without a penalty. So if you fall behind on rent one month, for example, you could use your 401(k) to pay it. You could also withdraw up to $22,000 to cover expenses related to a federally declared disaster. 

Can you take a 401(k) hardship withdrawal to pay off credit cards or loans? No, since that doesn't qualify as an immediate and financial need, according to the IRS. You could, however, get a 401(k) loan and use that for debt consolidation. 

401(k) hardship withdrawal vs. 401(k) loan

A 401(k) hardship withdrawal is a distribution from your retirement account. A 401(k) loan is a loan against your account's value. The maximum you can borrow is 50% of your vested balance or $50,000, whichever is less. 

Your vested balance is the amount of your 401(k) that you could take with you if you leave your employer. The money you contribute is always 100% yours. However, if your employer matches your contributions, those amounts may need to vest before you can legally claim them. For example, contributions may need to be in your account for five years before they fully belong to you. Some companies give a match that’s immediately yours.  

A 401(k) loan must be repaid within five years to avoid tax penalties. If you leave your employer before the five-year window is up, the rest of the loan balance has to be paid in full. Otherwise, it's subject to income tax and penalties. 

Here's a look at 401(k) hardship withdrawals and 401(k) loans, side by side. 

Can I take a 401(k) hardship loan?

There's no such thing as a 401(k) hardship loan; there are only hardship withdrawals or loans. If you're in a financial pinch, one may be better for your needs than the other. 

Advantages of a 401(k) hardship withdrawal

A 401(k) hardship withdrawal could be right for you if:

• Your financial hardship meets the IRS definition of an immediate and heavy need. 

• You don't want to have to pay back any of the money you withdraw. 

• You're comfortable with losing out on potential growth in your retirement account. 

You don't have to pass a credit check to qualify for a 401(k) hardship withdrawal. You just need to have a qualifying reason for taking money out early. You don't have to offer any collateral, like your home. And you don't have to pay anything back to a lender. 

Disadvantages of a 401(k) hardship withdrawal

A hardship withdrawal shrinks the value of your 401(k). Even small withdrawals could mean a smaller nest egg when you're ready to retire if you're missing out on growth. 

Aside from that, a hardship withdrawal could be difficult to qualify for if you don't have an eligible need. If your plan doesn't allow hardship withdrawals, this may not be an option for you at all. 

Tax considerations also come into play, and they could make a hardship withdrawal less attractive. 

Is there a penalty for taking out a 401(k) hardship withdrawal? 

Hardship withdrawals from a 401(k) are typically treated as early distributions if you're under age 59 ½. The IRS assesses a 10% early withdrawal penalty for those distributions. The only way to get around the penalty is to qualify for an exception. 

For example, you could avoid the penalty if you: 

• Are totally and permanently disabled

• Use the money for qualified education expenses

• Are a first-time home buyer

• Leave your job in the year you turn 55

The IRS list of exceptions is lengthy, but even so, it could still be difficult to get around the added penalty. 

Do you have to pay taxes on a 401(k) hardship withdrawal?

On top of a tax penalty, you may also have to pay income tax on hardship withdrawals. The only exception is if you withdraw money from a Roth 401(k), since it’s funded with after-tax dollars. In short, you already paid tax on that money. So, you don't have to pay it again when you make a withdrawal. You may, however, still get stuck with the 10% penalty. 

Penalties and interest could leave you with tax debt if you can't pay what you owe when you file. That could create more headaches if interest and penalties pile up. 

Alternatives to a 401(k) hardship withdrawal

A 401(k) hardship withdrawal might be on your radar, but consider how else you could get the money you need. Here are some alternatives to consider. 

Debt consolidation loan (if you qualify)

A debt consolidation loan lets you borrow money to pay off credit cards and other debts. You then have one payment to make toward the loan each month. If you qualify for a lower interest rate, you could also reduce your monthly payments. A consolidation loan could simplify your budget and help you repay what you owe faster. 

Balance transfer credit cards

Balance transfer credit cards let you move a balance from one card to another, sometimes at a lower interest rate. For example, you might open a new card with a 0% APR for 18 or 21 months. Balance transfers could save money, but only if you manage to clear the debt in full before the regular APR takes effect. Balance transfer 0% APR offers typically require good credit to qualify.

Debt settlement

Debt settlement lets you pay off credit cards for less than you owe. When you enroll in a debt settlement program, a debt expert negotiates with your creditors on your behalf. Settlement could help you get rid of debt in two to four years and potentially pay much less than you would if you stuck to a regular repayment plan. 

401(k) loan

A 401(k) loan could let you borrow a larger amount if you've accumulated a high balance in your account. However, you risk shortchanging your retirement when you take money out early. Aside from that, the tax consequences could get tricky if you decide to change jobs and can't pay off the rest of the loan in full. 

Should I take out a 401(k) hardship withdrawal or loan?

Unless you have absolutely no other options, you're better off leaving your 401(k) intact if you can. You might halt your contributions for a while if money is tight, but the contributions you've already made can continue to grow tax-deferred. And you don't have to worry about any unexpected tax bill that might follow if you withdraw from your account. 

Talking to a debt expert could help you decide how to move forward if you're in a hardship situation. Learn more about the debt relief options Achieve has to offer.