By: Todd Schanel, CFA, CPA, CFP®
on October 11, 2019

CPA_TaxAdvisor_401K_JupiterFL_Abacoa401(k) assets are generally not accessible to employees until they reach retirement age or leave their job. This can be frustrating to employees who are in urgent need of funds, perhaps even leaving them with no choice but to leave their job!  To alleviate this problem, the IRS allows 401(k) plans to permit what is called hardship distributions (also referred to as hardship withdrawals).  However, the rules for hardship withdrawals are stringent and the costs of taking a hardship withdrawal can be high.  Whether you are a plan participant or a plan sponsor, here is what you need to know.

Not every plan offers them

The first thing to know about hardship distributions is that just because the IRS permits them does not mean that every 401(k) allows them.  Each plan is different.  Many employers choose not to allow hardship withdrawals because of the added administrative burden.

Hardship withdrawals are taxable and subject to early withdrawal penalties

Second, hardship withdrawals are not tax-free!  Hardship withdrawals are subject to income tax and may be subject to a 10% early withdrawal penalty.  The point of a hardship withdrawal provision in a 401(k) plan is to provide active employees with emergency access to their funds, but it does not allow them to escape tax and penalty.

The rules are stringent

If a plan does permit hardship withdrawals, the general guidelines are as follows:

  • There must be an immediate and heavy financial need and no other resources are readily available.
  • All other possible distributions available under the plan must have already been exhausted.
  • Hardship withdrawals are allowed for the following types of expenses: medical expenses, purchase of a home, to prevent eviction or foreclosure, funeral expenses, higher education, and damage to a home, including damage caused by a federal disaster.
  • The withdrawal must be limited to the amount needed to satisfy the financial need, including any related taxes or penalties.
The IRS recently issued some new rules on hardship distributions

Recently, the IRS made some slight changes to the rules, which are effective for plan years starting after 12/31/18. Below are some highlights of those rule changes:

  • Former employees cannot take hardship withdrawals. However, a former employee can simply take a withdrawal of the entire balance, and rollover whatever they do not need into an IRA.
  • The employee must have already exhausted all other possible distributions available from the plan, but it’s no longer necessary that the employee first take a 401(k) loan before taking a hardship distribution.
  • The employee must provide the plan administrator with a request for the funds in an electronic format. This request must include a statement of urgent financial need and must confirm that no other resources are available. Email and recorded phone calls are both acceptable electronic formats. If the plan administrator has knowledge that contradicts the statement provided, the hardship distribution may be disallowed.
  • If the funds will be used to recover from losses that result from a federal disaster, the employee must live in the federal disaster zone, and the funds must be used for employee’s needs only.

If you have any questions regarding 401K hardship withdrawals, either as an employee or as a plan sponsor, feel free to contact our offices.

Schanel & Associates is a CPA firm specializing in accounting, tax, business valuation and litigation support serving Palm Beach, Martin and St. Lucie Counties and beyond since 1993. Our CPAs and accounting professionals work with individuals, businesses, estates and trusts to provide everything you need under one roof. For more information, contact us today at 561-624-2118.
Todd Schanel has been a principal at Schanel & Associates since 2004, where he specializes in financial planning, tax planning and consulting services. He also serves as Founding Principal and Director of Investment Advisory Services at Core Wealth Management, our sister company, where he leads an accomplished professional team offering independent and objective financial advice to help clients achieve their financial goals. Todd has been a CFA Charterholder since 2005, and in 2007 he earned his Certified Financial Planner® designation and became a licensed CPA. In 2015, he earned the Certified Valuation Analyst (CVA) designation.