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401k hardship withdrawals Know the stakes
DETROIT (4/24/12)--If you're like many Americans facing higher personal debt and a lower return on investments than you planned, you may have lost confidence that you'll ever have enough money to retire (Detroit News April 16). 

And yet, a sudden job downgrade, not being able to keep up with mortgage payments, or an expensive medical bill could leave you desperately looking for an immediate source of income.

Your 401(k) should be the last place you look for quick money. But if you've exhausted all other options, and your employer plan allows hardship withdrawals, you might have no choice but to tap in to your 401(k) retirement plan to help ease your financial burdens.

Before you do:

First, comb the fine print in your 401(k) plan to find out what qualifies as a hardship. Usually a hardship withdrawal must be due to an immediate and heavy financial need pertaining to certain medical expenses, specific home expenses including avoiding eviction or foreclosure, educational costs, funeral expenses, and the like.

Second, find out if you are eligible to take a hardship withdrawal. The Internal Revenue Service (IRS) says you must have exhausted all other options, such as stopping your elective deferrals, obtaining available loans, receiving compensation through insurance proceeds, or selling assets.

Third, learn how much is available to you. It's usually restricted to the amount you have contributed to the plan, without earnings, but some plans make employer contributions available as well.

Be aware that:

  • You will not be allowed to make elective deferrals for at least six months after you receive the withdrawal. This means you may make no new pretax contributions from your paycheck and you'll miss out on all or some employer matches during that time.
  • You will have to pay taxes on the amount you receive, based on your tax bracket.
  • If you're younger than 59½ years old, you will have to pay a 10% early withdrawal penalty.
  • In addition to the penalty, your plan might charge a fee to take a hardship withdrawal.
Don't go into this without understanding the consequences. First and most important is that you'll forego the compound earnings you'd otherwise enjoy in retirement.

To drive this home, say you are 30 years old, in the 25% tax bracket, and want $10,000 to pay for your tuition this year. To net $10,000 and pay the employer withdrawal fee and the IRS early withdrawal penalty plus taxes, you'll need to pull $15,485 from your retirement account. For the next six months you can't make any elective deferral contributions, and you'll miss your $2,700 employer's match. That's $18,185 that won't earn compounding interest--for the next 35 years.

Assuming you miss a 7% annual rate of return, you will come short roughly $194,000 when you retire.

In some situations it is worth taking the hardship withdrawal, but it should be your last resort. Consult with your human resources department, and with your tax and financial advisers before you make a hardship request. And use the calculator "The Cost of Borrowing From Your 401(k)" in the Home & Family Finance Resource Center to determine the ultimate consequence of this decision.
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