401(k) Hardship Withdrawals and Loans: What to Consider Before Accessing Your Funds Early

A 401(k) is designed as a retirement planning tool, but investors sometimes face unexpected financial situations that lead them to consider withdrawing funds from their 401(k) early. While a 401(k) is designed for long-term savings, you can access the funds early through hardship withdrawals and loans. However, there are consequences to this decision.

Here, we break down 401(k) hardship withdrawals and note what you should consider before accessing your retirement funds early.

What Are 401(k) Hardship Withdrawals?

A 401(k) hardship withdrawal allows you to access your retirement savings early (before the age of 59 ½), but only under specific conditions.¹ The IRS defines hardship as "an immediate and heavy financial need" and limits withdrawals to the amount necessary to satisfy that need.

Common reasons for a hardship withdrawal include:

Medical expenses for you, your spouse, or dependents
Preventing foreclosure or eviction from your primary residence
Funeral expenses for a family member
Tuition and related educational fees
Repairs for damage to your principal residence

Key Considerations for Hardship Withdrawals

If you have a significant nest egg saved in your 401(k) account, it may be tempting to want to access those funds to cover an immediate and heavy financial need. Still, there are some serious considerations you should take into account before doing so.

While hardship withdrawals are permitted in some instances, they still come with penalties. You will owe both federal and state income tax on the amount withdrawn, and if you are under the age of 59½, you'll also face a 10% early withdrawal penalty in most cases.²

In addition to the penalties and taxes, taking a hardship withdrawal reduces the amount of tax-deferred money growing in your account, which could severely impact your future retirement security.

Lastly, unlike a 401(k) loan, a hardship withdrawal cannot be repaid. Thus, the funds are permanently removed from your retirement savings. This consideration is critical because once those funds are withdrawn, you lose the principal and the potential for future earnings.

What Are 401(k) Loans?

A 401(k) loan is another option for accessing your retirement funds, but it works differently from a hardship withdrawal. With a loan, you borrow money from your 401(k) and agree to repay it, typically with interest, over a set period.³

With 401(k) loans, you’re required to repay the loan, usually through payroll deductions. If you leave your job, the loan must typically be repaid in full within a short time frame, or it will be treated as an early withdrawal subject to taxes and penalties.

When you take a 401(k) loan, you’re also required to pay interest on the loan. The good news is that this interest is paid back into your account, so you’re essentially paying yourself. However, the opportunity cost of having that money out of the market could outweigh the benefits.

Lastly, you can only borrow up to 50% of your vested account balance or $50,000, whichever is less. If you have a small balance, this might limit the amount you can access, making a loan less helpful in a major financial emergency.⁴

Alternatives to Consider Before Accessing 401(k) Funds

Before turning to a 401(k) loan or hardship withdrawal, it’s important to explore other financial options. Here are a few alternatives to consider:

Emergency Savings

Ideally, you should have an emergency savings account to cover unexpected expenses. Accessing these funds instead of your 401(k) preserves your retirement savings.

Personal Loans

Sometimes, a personal loan or home equity line of credit (HELOC) might be a better option. While these loans have interest, they don’t impact your retirement savings.

Credit Counseling

If you're experiencing financial hardship, working with a credit counselor or financial advisor can help you develop a plan that doesn't involve dipping into your retirement funds.

Life happens, which sometimes means you must pay for a large expense you didn’t see coming. While withdrawing the amount from your 401(k) is one option, there are a few considerations that investors should remember before taking out the funds.

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.