Qualifying for IRS Hardship Exceptions

Qualifying for IRS Hardship Exceptions

Figuring out how to qualify for a hardship withdrawal from your 401(k) or other retirement account can be confusing. There’s a lot of rules and regulations from the IRS about what counts as a valid hardship reason, how much you can take out, and how it impacts your taxes and retirement savings.

But sometimes life throws you a curveball and you need access to your retirement funds before retirement age. Medical bills, funeral costs, preventing foreclosure on your home – these are all potentially valid reasons to request a hardship withdrawal. The key is understanding the specifics so you can navigate the process smoothly.

What Counts as a Valid Hardship?

The IRS lays out some specific criteria for what counts as immediate and heavy financial need that warrants a hardship withdrawal. Here are some of the major categories:

• Medical expenses for you, your spouse, dependents, or primary beneficiary
• Costs related to purchasing your main home (not including mortgage payments)
• Tuition and education fees for the next 12 months for you, your spouse, children, dependents, or primary beneficiary
• Preventing foreclosure or eviction from your main home
• Funeral expenses for immediate family members
• Expenses to repair damage to your main home that would qualify for a casualty loss deduction

As you can see, the reasons focus on critical necessities – major medical issues, securing housing, education needs, and final expenses for loved ones. Getting a hardship withdrawal approved for vacations, credit card debt, or other non-essential costs is not allowed.

How Much Can You Withdraw?

The amount you can withdraw with a hardship request depends on the specifics of your situation. The minimum is $1,000, but there’s no set maximum. The withdrawal just needs to be limited to the amount you need to cover the financial hardship.

For example, if you have $7,000 in medical bills you can’t cover, requesting $15,000 for a hardship withdrawal probably wouldn’t get approved. You need to show the withdrawal aligns closely with the actual expense.

It’s important to remember that the amount withdrawn will count as taxable income, so you’ll want to take out extra to cover the taxes and potential penalties. For a $7,000 medical expense, you may need to withdraw $10,000 or more to end up with $7,000 after taxes.

Taxes and Penalties

Unlike normal 401(k) withdrawals in retirement, hardship withdrawals are subject to income tax and a 10% early withdrawal penalty if you’re under age 59 1/2. The taxes and penalty can really eat into the amount that ends up in your pocket.

For example, let’s say you withdraw $10,000 for a valid medical hardship. If you’re in the 22% tax bracket, you would owe $2,200 in federal income tax. Plus the 10% early withdrawal penalty would be another $1,000. So out of the $10,000, you’d end up with only $6,800 after paying taxes and penalties.

The income taxes on hardship withdrawals can’t be avoided, but there are a few ways to potentially get an exception from the 10% penalty:

• You’re totally and permanently disabled
• The withdrawal is used for qualified medical expenses over 7.5% of your adjusted gross income
• The withdrawal is used for qualified birth or adoption expenses
• You have deductible medical expenses that exceed 10% of your adjusted gross income (applies to IRA withdrawals only)

As you can see, the exceptions for the early withdrawal penalty are fairly limited. Make sure you consult with a tax professional to understand your specific situation.

Impact on Retirement Savings

In addition to taxes and penalties, hardship withdrawals also impact your overall retirement savings. The funds removed from your 401(k) or IRA no longer benefit from continued tax-deferred growth. And you lose out on any employer matching funds.

For example, let’s say you had $100,000 in your 401(k) and withdrew $10,000 for a hardship. If your investments were earning 6% annually, that $10,000 would have grown to over $26,000 in 20 years without the withdrawal. So the long-term impact can be significant.

The IRS does not allow you to replenish hardship withdrawals with make-up contributions later on. So once the money is out of your account, it’s gone for good.

However, you can continue making your regular ongoing contributions to your 401(k) or IRA after a hardship withdrawal. So it’s generally wise to keep contributing at least enough to get any employer match, if available.

Alternatives to Consider First

Because hardship withdrawals have so many downsides, it’s wise to consider other options first before tapping into your retirement funds. Here are a few alternatives to look into:

• Personal loans or lines of credit – Interest rates are fairly low right now
• Credit cards with intro 0% APR offers – Gives you over a year to pay back without interest
• 401(k) loan – Allows you to borrow from yourself and repay over 5 years
• Home equity loan – Interest may be tax deductible
• Asking for a billing grace period or payment plan – Many providers will work with you if you explain financial hardship
• Crowdfunding for medical bills or other urgent costs

The right alternative will depend on your specific situation. But taking the time to consider all options can potentially help avoid dipping into your retirement funds before you absolutely need to.

Steps to Request a Hardship Withdrawal

If you determine a hardship withdrawal is truly needed as a last resort, here are the typical steps to request one:

1. Contact your 401(k) or IRA provider to ask about their hardship withdrawal process. Every plan is a little different.
2. Request the necessary withdrawal forms from the provider.
3. Fill out the forms, including selecting the reason for hardship and amount to withdraw.
4. Gather supporting documentation for the hardship reason.
5. Submit the completed forms and documentation to the provider.
6. The provider will review and determine if it meets the IRS hardship withdrawal rules.
7. If approved, the funds will be withdrawn from your account and sent to you.
8. Remember, taxes and penalties will apply so set aside funds to cover them at tax time.

The documentation required will vary based on your specific hardship reason. Medical bills, tuition invoices, eviction notices, etc. Be thorough and submit everything needed to support your hardship claim.

The Bottom Line

Hardship withdrawals from retirement accounts should not be taken lightly. They can provide needed funds in an emergency but also derail retirement savings if used improperly.

Understand the rules, explore alternatives first, and only withdraw the minimum amount absolutely needed. Planning carefully can help minimize the long-term impact on your nest egg.

Sources:

IRS: Hardships, Early Withdrawals and Loans