How To Take A 401k Hardship Withdrawal Hardship withdrawals are one of two ways to take money out of your 401(k) plan while still employed by the company (the other is to borrow against your account balance). Unfortunately, there are tax and financial consequences that can make this a less attractive option for most people.

IRS regulations allow you to withdraw from your 401(k) plan to pay for qualifying emergency expenses if: (1) the withdrawal is due to an "immediate and heavy financial need"; (2) the withdrawal must be "necessary to satisfy that financial need" (i.e. you have no other savings or credit available that could be used to meet financial the need); (3) the withdrawal cannot exceed the amount of the financial need; (4) you must have first attempted to obtain all other distribution options or nontaxable loans available under the 401k plan; and (5) you do not contribute further to the 401k plan for six months immediately after your withdrawal.

The IRS considers the following types of expenses to be a sufficient "immediate and heavy financial need" to qualify for a hardship withdrawal: (1) Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care; (2)Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments); (3) Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents; (4) Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence; or (5) funeral expenses and expenses related to the repair of damage to the employee’s principal residence also qualify as an "immediate and heavy financial need" that will permit a hardship withdrawal.

While it can be tempting to just pull money out of your 401(k) whenever life throws you a financial curveball, there are several reasons why this is usually not the best option. There are significant tax costs involved, along with a major reduction of your total account balance at retirement.

First of all, you will be taxed on the amount of the withdrawal in the year it is taken. For amounts over $200, 20% federal income tax withholding will be deducted before you ever receive the money, along with any applicable state and local tax withholdings. If you are under 59½ at the time of distribution, you will also be required to pay a 10% early withdrawal penalty on your income tax return at the end of the year. To compensate for this, the IRS allows you to include the amount necessary to pay any income taxes or penalties "reasonably anticipated" as a result of the early withdrawal.

Even more financially damaging is the reduction in value of your portfolio over the years. The main benefit of any retirement savings plan is the tax-free compounding of interest over several decades of employment. Years of compound earnings are lost on every dollar withdrawn today. This lost interest cannot be made up by simply increasing future contributions.

Hardship withdrawals can provide a backup source of funds to cover unexpected financial circumstances, such as medical, tuition, and funeral expenses or to purchase a primary residence, but this does come at a steep price. Increased taxes in the year of withdrawal (plus a 10% early withdrawal penalty for those under 59½) and less money at retirement make taking a hardship withdrawal a poor long-term option.