A 401k is typically one of the last places you want to withdraw money because they’re so tax-advantaged. You’re depleting money from an account that offers you tax-free compounding, deferred until retirement (or completely tax-free with a Roth 401k).
When you take money out early (before the age of 59½) it’s regarded as a nonqualified distribution and could result in a 10% penalty in addition to income taxes.
However, sometimes life throws unexpected situations your way and you may end up with no other option than to dip into your 401k savings. If that’s the case, there are two options for you to consider: a 401k loan and a hardship withdrawal. In this article, we’ll look at the differences between the two options, the tax implications behind them, and how to choose what’s better for your given situation.
401k hardship withdrawal vs 401k loans overview
Before we dive in, here’s a quick overview of all the major differences between the two options.
|Feature||401k hardship withdrawal||401k Loan|
|Eligibility||Can only withdraw for qualified reasons of hardship.||Can take a loan for any reason as long as your plan provider offers a loan option.|
|Amount||You can only borrow the necessary amount required to satisfy the financial need, plus any additional amount to cover taxes on the withdrawal.||You can borrow up to 50% of your account value, up to a maximum of $50,000.|
|Taxes on withdrawal||Taxed as ordinary income.||None|
|Penalties on withdrawal||None||None|
|Repayment||No repayment required since a hardship withdrawal is a distribution.||Required to pay back the money within 5 years (up to 15 years if used to purchase a primary residence).|
401k hardship withdrawals
The IRS lists certain situations where you’re allowed to withdraw from your 401k without early withdrawal penalties, even if you’re under the eligible retirement age of 59½.
You’ll still have to pay ordinary income taxes on the withdrawal. The amount you withdraw due to hardship gets added onto your taxable income for the year.
What counts as a hardship withdrawal?
While the specific criteria can be decided by your plan provider (some providers choose not to allow hardship withdrawals at all, or may have stricter restrictions), the IRS lists the following exceptions as eligible reasons for hardship withdrawals:
- Death: If you pass, your beneficiaries can withdraw the money from your 401k without penalties.
- Burial and funeral: You can withdraw from your 401k to cover burial and funeral expenses for a spouse or dependent.
- Disability: If you become totally and permanently disabled.
- Medical expenses: If you need funds to cover unreimbursed medical expenses for yourself or a dependent. The expenses must be under 10% of your adjusted gross income (AGI).
- IRS levy: You can use your 401k funds without penalties to pay an IRS levy on the plan due to a tax debt.
- Birth or adoption expense: If you give birth or adopt a child, you’re allowed to withdraw up to $5,000 within one year after the birth or adoption.
- Substantially equal periodic payments (SEPP): You can take substantially equal periodic payments (SEPP) from your 401k if you’re no longer employed with the company sponsoring the plan.
- Military: If you’ve been ordered or called to active duty after September 11, 2001, for an indefinite period, or for longer than 180 days, you can withdraw from your 401k penalty-free. The withdrawal must be made during your time of service in order to be eligible.
Do I have to pay taxes on a hardship withdrawal?
Yes, hardship withdrawals only apply to penalties. Because it’s still a distribution, you’ll have to pay ordinary income taxes on your withdrawal amount (the withdrawn amount gets added to your taxable income for the tax year).
How much am I allowed to withdraw?
You are only allowed to withdraw the necessary amount to satisfy the financial need, in addition to any excess amounts required to cover taxes on your withdrawal. Only hardship withdrawals to pay for birth or adoption expenses have a set limit of $5,000. This is a lifetime limit, not a per child limit.
How long will it take to receive my funds?
It can take between 7 to 10 business days to receive your hardship withdrawal funds if receiving funds through check. Receiving the funds through direct deposit is usually faster at 3 to 7 business days.
- You can only take a 401k hardship withdrawal while you’re still working for the employer sponsoring your plan.
- Some 401k plans do not let you make any further contributions for six months after taking a hardship withdrawal.
If your 401k plan offers the option to take out a loan, you’re allowed to borrow money from your own account. You can borrow up to 50% of your account’s value up to a maximum of $50,000.
Unlike a hardship withdrawal, there are no eligibility rules or restrictions on how you use the money. You can use the funds for whatever you want, and you’ll have 5 years to pay it back. Some loan providers offer longer repayment periods if you use the money to purchase a primary residence, and you may be able to get up to 15 years to repay the money.
What are the interest rates?
The interest rate on a 401k loan is prime rate plus one or two percent. All interest payments go back into your own 401k account.
What if I don’t pay back the loan on time?
If you don’t pay back the loan on time, it gets treated as a distribution. If you’re under the eligible withdrawal age of 59½, you’ll also be hit with the 10% early distribution penalty tax.
Benefits of a 401k loan
A 401k loan is one of the easiest and quickest ways to borrow money since it doesn’t act like a traditional loan through a creditor. You’re lending the money to yourself.
There are no credit checks, and if you fail to pay the money back, there is no affect on your credit. Because there are no credit checks, there’s also no lengthy application process. Nobody needs to analyze and approve your application. The process takes just a few business days.
Additionally, the interest rates are lower than personal loans or credit cards and the interest payments go back into your own 401k account.
But perhaps the best part of a 401k loan is that there are no taxes and no early distribution penalties like with a 401k hardship withdrawal. As long as you pay the money back within the deadline, the loan is tax and penalty-free.
Disadvantages of a 401k loan
The biggest disadvantage of a 401k loan is that you’re diminishing your retirement account of funds that would otherwise be invested with tax-free compounding. But to be fair, a hardship withdrawal would also have the same effect on the account.
The other disadvantage is that you’re somewhat tied to your employer. This is because if you leave your employer, or get terminated, the 5-year repayment period disappears. You’ll have to pay back the loan in full by the following year’s federal tax deadline.
- Not all plan providers offer the option to take a 401k loan.
- Some plans will not let you make further contributions to the plan until the loan is repaid.
- If further contributions to the plan are now allowed until repayment, you’ll also miss out on employer match contributions.
- There’s a double tax to keep in mind: There are no taxes when you take out the loan, but money used to repay the loan must be made with after-tax income (money you’ve paid income taxes on). When you take qualified withdrawals from your 401k in retirement, you’ll have to pay taxes again.
Does the 401k hardship withdrawal and 401k loan apply to a solo 401k as well?
Yes, a solo 401k has the same features and rules as a 401k when it comes to hardship withdrawals and loans. For example, the Ocho Solo 401k Plan offers both hardship withdrawals and the ability to take out a loan from your account.