If you encounter a financial hardship, you may be able to tap into the savings in your 401(k) to pay certain debts or obligations, but you'll owe taxes on any money you withdraw, plus a 10 percent early withdrawal penalty. Each retirement plan sets its own rules for hardship withdrawals, though the Internal Revenue Service sets some guidelines. Your 401(k) manager can provide specific rules for taking a hardship distribution from your plan.
Definition of a Hardship
The IRS defines a financial hardship as a need that is "immediate and heavy." Examples of hardships include medical expenses, funeral expenses, money to repair damage to a principal residence, tuition and other education expenses or money needed to prevent eviction or foreclosure. You must exhaust other resources before you can turn to your 401(k) as the source of funds. For instance, if you have other assets, such as a vacation home, that you could sell and use the proceeds to pay your bills, the IRS doesn't view you as qualifying for a hardship distribution from your 401(k).
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Retirement plans may set their own rules about the types of hardships that qualify for a withdrawal. For instance, a plan may decide to make hardship distributions for funeral or medical expenses but not for housing or education expenses. The plan also decides what the employee must do to show a need for the hardship distribution. Some plans may accept a simple statement from the employee, while others may require a copy of an eviction notice or a tuition bill.
Limits on Withdrawals
You may only withdraw the amount needed to relieve your hardship, plus any taxes or penalties. If you take a hardship withdrawal to repair your house after a flood, for example, you can't take extra money to remodel your bedroom also. You may only withdraw an amount up to or equal to your contributions to your 401(k), plus any profit sharing or matching funds, but not the earnings on those funds.
An employee may take a hardship distribution because of a need his spouse has; the same goes for a dependent who lives with the employee and has a need that meets the plan criteria for hardship. For example, you could use a hardship distribution to pay medical bills for your mother who lives with you or tuition bills for a child who lives with you when she is not away at school. Once you've taken a hardship distribution from your 401(k), you may not contribute to the plan for a minimum of six months. Hardship distributions aren't repaid like loans, so they decrease the amount you have contributed toward your retirement savings.