Small Business 401(k): Hardship Withdrawals Explained

Author: Siân Killingsworth / 11 Sep 2023 / 401(k) Plan Information, Personal Finance

Owning a small business comes with a lot of responsibilities, including planning for the future. It’s important to save for retirement, but there are times when life throws a wrench into your financial plans. That’s when you may consider options like a hardship withdrawal from your 401(k). The following aims to give you a thorough but easy-to-understand overview of hardship withdrawals. We’ll explore what it is, its pros and cons, and what you should consider before taking this significant step.

What is a Hardship Withdrawal?

In simple terms, a hardship withdrawal allows you to take some money out of your 401(k) retirement plan if you find yourself in a tough financial situation that requires immediate action. This option is regulated by both the IRS and individual 401(k) plan guidelines to ensure it’s used only for urgent and substantial financial needs.

When Can You Make a Hardship Withdrawal?

The IRS has identified several circumstances where a hardship withdrawal would be allowed. Generally, you can use this option for:

• Unexpected Medical Bills: If you or a family member falls seriously ill and you’re facing hefty medical bills, a hardship withdrawal can be a lifesaver.
• Buying a Home: If you’re buying a home to live in (this doesn’t include a vacation home or investment properties), you can tap into your 401(k).
• Education Expenses: This includes school fees and tuition for post-secondary education for you or your dependents.
• Preventing Home Loss: If you’re on the verge of eviction or foreclosure, a hardship withdrawal can help you keep your home.
• Funeral or Burial Costs: If you have to arrange a funeral or burial for a family member, you can use this money to cover the costs.

Advantages of Hardship Withdrawals

1. Immediate Financial Relief: One of the most significant advantages of a hardship withdrawal is that it provides quick financial help when you’re in a bind.
2. No Early Withdrawal Penalty: If you’re under the age of 59 ½, taking money out of your 401(k) usually comes with a 10% penalty. This penalty is waived for hardship withdrawals, making it easier on your wallet.
3. Freedom of Usage: The money you withdraw isn’t a loan, so there’s no need to worry about monthly repayments. This can reduce stress during an already stressful time.
4. Straightforward Application: Most 401(k) providers have a streamlined process for applying for a hardship withdrawal. This makes it easier for you to get the money you need without jumping through too many hoops.

Disadvantages of Hardship Withdrawals

1. Lower Retirement Savings: The most obvious drawback is that you’ll have less money saved for your retirement. This affects not just the total amount you’ll have, but also the interest that the withdrawn money could have earned over time.
2. Tax Liabilities: Although you escape the 10% early withdrawal penalty, you’ll still have to pay regular income tax on the withdrawn amount, which could bump you into a higher tax bracket for the year.
3. Pause in Contributions: Some 401(k) plans require you to stop adding new contributions for six months or so after a hardship withdrawal. This could delay your retirement savings plan and goals.
4. Documentation: You’ll need to prove that you’re facing a financial emergency, and this can sometimes require a good amount of paperwork, which can be time-consuming.

Alternatives and Final Thoughts

Before deciding on a hardship withdrawal, it’s essential to consider other options that could be less disruptive to your long-term financial planning. Could you take out a loan at a reasonable interest rate? Or could you adjust your budget to create an emergency fund over time?

While a hardship withdrawal can offer a financial lifeline in pressing situations, it should be carefully considered. If you’re contemplating such a withdrawal, consulting a qualified financial advisor can provide valuable insights tailored to your circumstances. They can help you weigh the pros and cons based on your specific financial situation and long-term goals.