Understanding Hardship Distributions: When and Why They Matter

When financial emergencies strike, employees may find themselves needing immediate access to funds they've set aside for retirement. In such cases, some may turn to a feature in their 401(k) plan known as a "hardship distribution." But what exactly is a hardship distribution, and how does it work?

A hardship distribution allows an employee to withdraw funds from their retirement account before retirement age, specifically to cover pressing financial needs. Unlike a typical loan from a retirement plan, a hardship distribution doesn't need to be repaid. However, it comes with its own set of consequences, including taxes and potential penalties, making it a choice that requires careful consideration [1].

"A hardship distribution is a withdrawal from a participant's elective deferral account made because of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need." - Internal Revenue Service [1]

The Criteria for Hardship Distributions

For a withdrawal to qualify as a hardship distribution, the IRS requires that it meets two key criteria. First, the need must be immediate and heavy. This means the employee must face a financial situation that requires urgent attention—situations like preventing eviction or foreclosure on a primary residence, covering funeral expenses, or paying for unreimbursed medical costs. The second criterion is that the withdrawal amount cannot exceed what's necessary to meet this financial need, plus any taxes or penalties that may result from the distribution [2].

Employers also play a role in determining eligibility for hardship distributions. They may require employees to exhaust other financial resources, such as taking a loan from their retirement account or liquidating other assets, before approving a hardship distribution [3].

The Costs of Early Withdrawal

While hardship distributions provide a financial lifeline in times of need, they come at a cost. The most immediate is taxation—funds withdrawn are considered taxable income. This means that if you're in a higher tax bracket, a significant portion of your withdrawal could go to the IRS. Additionally, if you're under the age of 59½, a 10% early withdrawal penalty usually applies, further reducing the amount of money available to meet your financial emergency [4].

There's also a long-term cost to consider. Taking money out of your retirement savings today means you'll have less money growing tax-deferred for your future. This can significantly impact your retirement goals, especially if you don't have a strategy for replenishing the withdrawn funds [3].

"Keep in mind that you won't be able to return the funds to the account if your finances improve." - Investopedia [3]

Why Employers Should Care

For employers managing a 401(k) plan, offering the option of hardship distributions can be an important part of supporting employees. However, it also introduces complexity in terms of plan administration and fiduciary responsibilities. Employers must ensure that hardship distributions are granted in accordance with IRS regulations and that proper documentation is maintained. Failure to comply can result in penalties for the employer and the plan itself [5].

Employers can also take proactive steps to minimize the need for hardship distributions by offering financial wellness programs that help employees better manage their finances. By encouraging employees to build emergency savings and understand the long-term impact of withdrawing retirement funds early, employers can support both the immediate and future financial well-being of their workforce [5].

Final Thoughts

Hardship distributions are a critical feature for employees facing financial crises, but they should be used sparingly and with full awareness of the costs involved. For both employees and employers, understanding the rules and implications of hardship distributions is essential to making informed decisions that balance immediate needs with long-term financial health.

For support in managing your fiduciary responsibilities, visit Fiduciary In A Box.

© 2024 Fiduciary In A Box, Inc. All rights reserved.

References

 [1] Internal Revenue Service. (2024, April 1). Hardships, Early Withdrawals and Loans. Retrieved from https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans 

 [2] Internal Revenue Service. (2024, May 7). Retirement Plans FAQs regarding Hardship Distributions. Retrieved from https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions  

 [3] Kagan, J. (n.d.). What Is a Hardship Withdrawal? Definition, Rules, and Alternatives. Investopedia. Retrieved from https://www.investopedia.com/terms/h/hardship_withdrawal.asp 

 [4] Carlson, B. (2024, February 28). 401(k) And IRA Hardship Withdrawals – Avoid Penalties. Bankrate. Retrieved from https://www.bankrate.com/retirement/401k-and-ira-hardship-withdrawals-ways-to-minimize-taxes/ 

 [5] Brandon, E. (n.d.). How to Take 401(k) Hardship Withdrawals. U.S. News & World Report. Retrieved from https://money.usnews.com/money/retirement/401ks/articles/how-to-take-401-k-hardship-withdrawals