401(k) Hardship Withdrawal Rules 2021

Author: Siân Killingsworth / Reviewer: Callie Adams Farnsworth, QKA, CAFCA
1 Feb 2021 / 401(k) Plan Information

The pandemic has led to serious hardship for many Americans, including furlough, job loss, illness, and lost business income.

When facing unexpected financial challenges such as these, most advisors recommend cutting expenses, taking money out of emergency savings, tapping your brokerage account, or putting expenses on a 0% interest credit card rather than raiding your retirement nest egg. However, borrowing from your 401(k) may suddenly seem like a risk worth taking if these other options are not available to you.

December 30th, 2020, was the last opportunity to take advantage of eased CARES Act hardship withdrawal rules, but you may qualify for conventional relief in 2021. If you already took a withdrawal in 2020, you’ll need to know the payback rules to ensure you don’t rack up additional penalties.

Can You Take a 401(k) Hardship Withdrawal in 2021?

The IRS defines eligible 401(k) hardships as “immediate and heavy financial needs.” These needs generally include:

• Medical care
• Tuition
• Emergency home repairs
• Funeral costs
• Eviction prevention

The purchase of a boat, investment property, or television would not be considered a heavy financial need. However, in 2020, the CARES Act created a provision that allows for a hardship withdrawal for people whose health or finances have been impacted by COVID-19.

Not all plans permit hardship withdrawals, so you will need to check with your 401(k) provider or sponsor to see if this opportunity exists for your particular plan. If it is permitted, you will have to demonstrate that you lack available funds to cover your expenses.

401(k) Hardship Withdrawal Rules 2021

If your plan allows for early distribution, the 401(k) hardship withdrawal rules for 2021 are as follows:

• You can only withdraw what you need. If you’re seeking money to fix your house after a flood and receive an estimate for $10,000, that is how much you’ll be approved to borrow. You make take out additional funds to cover related costs like tax or replacement furnishings. The CARES Act set a COVID-19 withdrawal limit of 100% of the vested balance, to a maximum of $100,000. (Under normal circumstances, hardship withdrawals are limited to 50% of your balance or $50,000.) This maximum includes all amounts withdrawn from tax-advantaged savings accounts, so you can’t raid IRAs, 403bs, and multiple 401(k)s.
• What you borrow may be subject to tax and penalties. Hardship withdrawals are typically subject to income tax and a 10% early withdrawal penalty (for those under age 59.5). The 10% penalty is waived for COVID-related hardship withdrawals, and you may spread out the tax payments on the amount borrowed over the course of three years.

Who Qualifies for COVID-related 401(k) Hardships in 2021?

The IRS allows withdrawals for COVID-related 401(k) hardships if:

• You, your spouse, or a dependent are formally diagnosed by a CDC-approved test.
• Your household suffers a financial setback from quarantine, furlough, a layoff, or reduced hours.
• Lack of child care due to COVID-19 causes adverse financial consequences.
• The business you own or operate had to reduce hours, limit capacity, or close because of the virus.

Is There a Deadline for COVID-19 Withdrawals?

The deadline for a 2020 tax year withdrawal was December 30th, 2020. The IRS is continually updating their rules along with this fluid situation, so it is possible they will formally announce some type of relief applicable to the 2021 tax year as the pandemic persists.

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Is There an Extended Deadline for Repaying Hardship Distributions?

If you took a hardship loan prior to the 2020 COVID-19 pandemic with repayment due between March 27 and December 31, 2020, the CARES Act allows you to delay this repayment by up to one year.

Managing the Tax Hit of a 401(k) Hardship Withdrawal

If you took money out in 2020, you are allowed the opportunity to repay the money back into your account over a three-year period to avoid paying income tax on the distribution. So, for instance, if you borrowed $9,000, you could repay $3,000 in 2020, 2021, and 2022. There is no rule stipulating you must space your repayments out evenly. If you’re still hurting at the end of 2020 and even through 2021, you may elect to repay the full $9,000 in late 2022.

If you cannot repay the amount borrowed from your 401(k) over the next three years, that money will be taxed as income – and you will be subject to the interest and penalties that have accrued since you took the money out. The lowest tax bracket is 10%, so that means you’d owe at least $5,000 in taxes if you took out $50,000. Typically, plan participants only have 60 days to redeposit early withdrawals, so the CARES Act’s three-year window is exceedingly generous.

Were Hardship Withdrawals a Popular Option During the Pandemic?

According to data collected by Vanguard:

• About 5.3% of 401(k) plan participants withdrew CARES Act distributions through November 2020.
• The majority of retirement account holders stayed the course with mutual funds, stocks, and bonds.
• The median age of someone taking a CARES Act withdrawal was 43.
• The median income was about $62,000.
• The median amount withdrawn was $12,800.

How to Get Your 401(k) Back on Track After A Hardship Withdrawal

The biggest downside of taking an early withdrawal is that you lose potential growth on your investments and the momentum of compounding interest. If you’re between the ages of 30-50, simply boosting your retirement savings by 1% per paycheck could be enough to rebound from the 401(k) withdrawal. Workers between the ages of 50-70 may need to save more aggressively, depending on how much they’ve accrued, how much they’ve recently borrowed, and how soon they wish to retire.

How to Learn More About 401(k)s, Hardship Withdrawals, and IRS Rules for 2021

Ubiquity is a top provider of Solo 401(k) and small business 401(k) plans. If you have any questions about opening a new retirement account or taking full advantage of an existing 401(k), contact us for expert advice.