You've worked hard to build up your workplace retirement plan balance, but life is full of unexpected developments. You may face a financial emergency before your retirement, which is why many plans allow you to take a hardship withdrawal from your account. Be aware however that taking a hardship withdrawal comes with a steep price tag—for both now and later.
Think Twice Before Taking a Hardship Withdrawal
If you're younger than 59½, you may pay ordinary income taxes plus a 10% early withdrawal tax penalty on the amount you withdraw.
- You may not be allowed to contribute to the plan for at least six months.
- You'll miss out on the potential tax-deferred growth of both the amount you withdraw and your stopped contributions.
Hypothetical example: Ed, who is 40 years old and in a 25% tax bracket, needs money for a down payment on a house. He decides to take a hardship withdrawal of $10,000 from his plan. After paying $2,500 in federal income taxes, plus a $1,000 penalty for early withdrawal, he's left with only $6,500. His future loss is even greater: At a hypothetical 6% return compounded weekly over 20 years, that $10,000 would have grown to $33,178. *
About Hardship Withdrawals
- Most plans allow hardship withdrawals.
- Hardship withdrawals operate under strict IRS and plan guidelines.
- You must show a significant and pressing financial need.
- You may have to exhaust all other financial resources or options, such as taking a plan loan.
- Some plans limit financial hardship to unforeseeable emergencies, such as medical expenses, funeral costs, and foreclosure or eviction.
- Many plans expand hardship definitions to include other needs, such as educational expenses or the purchase of a home.
Create Your Own Safety Net
As we live longer in retirement, it's more important than ever to keep your money growing for when you'll need it most. A few simple steps can help you keep your retirement plan savings off-limits: establish an emergency fund covering three to six months of expenses; create a separate housing account for a down payment; and explore tax-deferred college savings plans.
Taking a hardship withdrawal could have a dramatic effect on the size of your nest egg in retirement. Be smart and use this option only as a last resort. You may want to consult a financial professional before making your decision.