Opinion: Hardship withdrawals from a 401(k) will get easier soon, but not quite yet

If you’re getting crushed by inflation and you have any money sitting in your 401(k), you may be wondering how you can get at it. In that kind of situation, something called a “hardship withdrawal” sounds like it would fit the bill. But the Internal Revenue Service has six designated ways that you can show an “immediate and heavy financial need” to take money out if you’re younger than 59 ½ and inflation isn’t one of them. 

There’s no wiggle room on this, but the rules will start to change in the future when provisions of the omnibus spending bill come into effect in 2024. The new bill allows companies to create emergency savings accounts for workers attached to their 401(k)s, which can hold up to $2,500 and take out up to $1,000 for emergencies. There are also provisions that open up funds for those who are victims of domestic violence.

But for now, you still have to meet one of the existing criteria — medical expenses, funeral expenses, first-time house purchase, upcoming tuition, disaster home repairs or preventing eviction — and be able to document your need. You can generally take out up to the amount of your contributions and you’ll pay income tax on it, but you could avoid the 10% additional penalty for early withdrawals. You no longer need to exhaust all other options, like loans, first, as long as you can demonstrate that you have no other way to get the funds you need.

Hardship withdrawals are not like a 401(k) loan, where you take out, say, $5,000 with generally no questions asked, and you then pay yourself back over time.

For medical expenses and funeral expenses, you would need to show receipts that add up to the requested amount. For costs related to the purchase of a principal residence or for tuition for the next year, you’d have to produce the bills. If you’re facing eviction, you’d have to show the notice. In the case of the natural disaster, you’d have to document the event and the costs to repair the damage to your principal residence. 

Nevertheless, hardship withdrawals are increasing by an alarming amount, according to new data from 401(k) custodians. At Vanguard, hardship withdrawals reached a “concerning” record high, outpacing increases in loans and non-hardship withdrawals from retirement accounts. Fidelity and Ubiquity also noted an increase in all three areas. At Ascensus, hardship withdrawals are up 33% from the same time last year, while loans are only up 15%, and withdrawals are up 22%. 

“It could be a sign of the general deterioration of financial health,” says Rick Irace, chief operating officer of Ascensus. 

Paperwork trail

When you submit a hardship-withdrawal request, the first stop is most likely to the web portal for your retirement-plan custodian, where you can click a few buttons and tell them what you need. The information is routed to your employer’s human resources department, where it will either be evaluated by someone or passed along automatically if your plan allows for self-certification.

At some point, an auditor who is a fiduciary will look at it and make sure it’s legitimate, or in the end, the IRS may deny the waiver for the withdrawal and then you’ll end up with a tax headache.

That’s why an inflation-related request will likely get dinged along the way. Todd Feder, a vice president and senior retirement-plan consultant at Girard, recently had to stop a request in progress through a plan he advises because it didn’t meet the hardship requirements. “An employee went to the plan sponsor and said inflation is going up, I’m having a baby and I need money to pay my mortgage. And they approved it, but that’s not allowed,” Feder says. 

Instead of just turning down the request, Feder found a creative solution. “When we found out about the baby, we collected statements about the medical expenses, documented that it was for medical reasons and maintained the paperwork for the fiduciary file,” he said. “It’s not easy.”

Tap other options first 

Irace meets with many plan participants as part of his job at Ascensus, and he tries to talk with those asking for withdrawals about the other options that they might have before claiming a hardship. “I try to tell people, you’re borrowing from your future if you’re doing that,” he says. 

But he finds that they don’t generally understand the rules, and they find it frustrating that they have money that they need but can’t access. At Ascensus, they can actually put a number on this discontent. “We have a 96% overall satisfaction rate at our call center, and 3% of the dissatisfaction is driven by people who call and want to take their money out, and can’t because the plan does not allow it,” says Irace. 

The withdrawal process is somewhat easier with other retirement accounts.

With a Roth IRA, for example, you can take out your contributions at any time, as long as your account has been open for five years. With a traditional IRA, you can take withdrawals before 59 ½ for similar reasons as a hardship withdrawal and avoid the 10% penalty if you substantiate the exemption. And you can also take out money as a straight withdrawal if you pay the 10% penalty and the tax.  

There are also easier ways to get money out of 401(k)s. Most plans allow loans, and they’re generally the best option in the sense that you’re paying yourself back with interest and there is no IRS penalty or tax involved. 

But, “that can be difficult to do if you’re in a time of financial stress,” says David Stinnett, head of strategic retirement consulting for Vanguard

In addition, you’re limited in the amount to $50,000 or half the vested value, whichever is greater. And if you leave the job while the loan is still active, you have to pay it back immediately or pay tax and a penalty on the remainder. 

You can also do an in-service withdrawal, where you’re allowed to take money out and pay the tax and penalty, but note that those are generally limited to those over 59 ½, although some plans do allow them for younger participants. 

Impact to retirement readiness

All the options for taking money out of retirement accounts impact your long-term retirement prospects. “A lot of people think they can take money out because they can always live off Social Security, but you need something to supplement that,” says Callie Farnsworth, director of compliance for Ubiquity, a retirement-plan administrator. 

“My recommendation is always to attempt to plan for unforeseen events, but not everyone can do that. Past that, education is key, so you know the options to pull money out, and know that if you do, you’re going to incur some tax.”

For Irace, the education component largely comes down to engagement. People who are generally involved and seeking information tend to do better. “People who log in once a year — you look at something or take an action — our stats show that they have a 25% higher balance than somebody who never logs in,” says Irace. “There’s something to the engagement factor.”

Got a question about the mechanics of investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write me at [email protected].  

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Source: https://www.marketwatch.com/story/inflation-isnt-reason-enough-for-a-hardship-withdrawal-but-you-can-get-money-from-your-retirement-if-you-follow-these-rules-11671484286?siteid=yhoof2&yptr=yahoo