Over the past several years, we have witnessed a global pandemic transpire, inflation skyrocket, and prices of everyday items markedly increase. These events have forced many Americans to look to alternative sources of money to pay for necessities like shelter, groceries, and gas – among others. With many people’s paychecks already being stretched thin due to increased costs for most goods and services, some have looked to retirement funds to assist in paying for necessities. When deciding if drawing on retirement funds is appropriate, it is important to know the options available and the tax ramifications in each instance. Below are a couple of options available and the tax consequences associated with each option.
The first option is a 401(k) hardship distribution. If a 401(k) plan allows for it, participants have an option for withdrawing money from their account. However, the IRS has strict guidelines that must be followed to avoid penalties. The distribution can only be made if it is 1) due to an immediate and heavy financial need and 2) limited to the amount necessary to satisfy that financial need. The IRS defines an immediate and heavy financial need as any one of the following: medical care, costs directly related to the purchase of a principal residence, tuition (or related educational expenses), payment necessary to avoid eviction or foreclosure, funeral expenses, or certain expenses to repair damage to a principal residence. Unfortunately, hardship distributions are subject to ordinary income tax (unless they consist of Roth contributions) and early withdrawal penalty (if under 59½) of 10% federal and 2.5% state (California). Additionally, participants who take a hardship cannot repay it back to the plan or roll it over to another 401(k) plan or IRA.
The second option for withdrawing funds to help meet current living needs is to take a loan from a 401(k). If a 401(k) plan allows loans, the IRS limits the amount that participants may take to the lesser of 50% of the vested account balance or $50,000. One exception to this limit states that if 50% of the vested account balance is less than $10,000, then up to $10,000 may be withdrawn. Since this is a loan, participants will need to pay the borrowed money back, plus interest – the interest rate on most 401(k) loans is the prime rate plus 1-2%. Lastly, the loan must generally be repaid within 5 years, with some exceptions. There are no taxes or penalties associated with taking a loan from a 401(k).
Unlike a 401(k), investors are not able to take a loan from a traditional or Roth IRA. However, there are ways to get money out of an IRA without penalty, including if you are over 59½, you qualify for an exception, if the account is a Roth IRA (certain limitations apply), or if the money is replaced within 60 days (known as a 60-day rollover).
Please reach out to your financial professional to discuss your specific situation to see if taking money from a retirement account is the best option for you and, if not, what other options may be available.