News reports indicate a record number of people are taking hardship withdrawals from their 401k accounts. As the name suggests, the rules permitting these withdrawals are intended to provide a measure of relief from economic hardship. In most cases, though, people taking these withdrawals will end up suffering more hardship, not less.
One of the bad things about saving in a 401k or similar plan is that they don’t provide unfettered access to the money in your account. That’s also one of the good things about saving in these plans. The barriers they create between you and your money make it less likely that you’ll shoot yourself in the foot by wiping out your retirement savings long before you’re retired.
Generally you can withdraw your money after “termination of service” — after you retire, quit, or lose your job — but a hardship distribution may be the only way to withdraw money before then. This is a distribution that’s necessary to meet “an immediate and heavy financial need” of the employee or his or her spouse or dependent. Federal law limits what can be considered a hardship, and companies are free to impose stricter limitations.
Recent economic conditions have produced more hardship than normal, so it isn’t surprising that we’re seeing an uptick in hardship withdrawals. People taking advantage of this safety valve lose three ways.
First, the distribution will show up as taxable income on your return for the year of the withdrawal. Withholding from the distribution (the employer holds back 20%) may not be enough to cover this tax, so you may end up with a tax bill in April.
Second, a 10% early distribution penalty is likely to boost that tax bill. Unless you qualify for an exception, you pay this penalty whenever you take a taxable distribution before age 59½. The law provides a number of exceptions, but there’s no general hardship exception.
The biggest penalty of all, though, is a silent and invisible one. Money saved in a qualified retirement plan is a key component of your long-term financial security. You lose the golden opportunity to grow this money with decades of tax-free compounding if you pull it out as a way to deal with a short-term financial crisis. Taking a hardship withdrawal now makes it likely you’ll have a less comfortable and secure retirement.
These detriments are especially poignant in situations where the hardship distribution ends up doing no good at all. We’ve heard of people draining their retirement savings to avoid foreclosure, only to end up losing the home anyway. Similarly, it’s a tragic waste to pull money from a 401k to delay a bankruptcy that can’t be avoided. This money would have been protected from creditors in a bankruptcy. Adding insult to injury, a tax debt owed because of the hardship withdrawal normally won’t be discharged in bankruptcy. A hardship withdrawal can cause someone who would have started post-bankruptcy life with some retirement savings to begin instead with a tax debt that could have been avoided.
No doubt there are situations where a hardship withdrawal is the lesser evil. For many of the people taking these distributions, however, the hardship caused will be greater than the hardship relieved.