401K Hardship Withdrawals: What Qualifies & What It Means to You
By Michael Mikonis, CFP®, RICP®
With nearly 18,000,000 Americans out of work as of August 6th, 2020, many people we know are going through financially trying times. Coronavirus pandemic has put millions of people out of work across the country, virtually overnight, and a few months in - many are running out of cash resources to stay current with their bills.
Many people have saved for their retirement years in 401K plans, which typically do not allow distributions until one is 59 ½, retires or changes employment. However, it can become a true lifeline if you can qualify for a “Hardship Withdrawal” if your plan allows for such a distribution.
There are standard IRS rules that govern Hardship Withdrawals during normal times, but we all know that COVID Pandemic has turned this year into anything but normal. In response to the economic impact from Coronavirus, Congress took action and relaxed some of the rules governing 401K withdrawals for 2020. Let’s take a look at under what circumstances you can take money out during normal times, and when you can take money from your retirement savings accounts in the times of COVID.
There are seven reasons that would qualify one to withdraw funds from their 401K prior to age 59 ½:
Expenses and loss of income, experienced if you live in an area designated as “Disaster Area” by FEMA.
Payments necessary to prevent eviction from or foreclosure on your primary residence.
Expenses for the repairs of damage to your primary residence.
Burial or funeral expenses.
Tuition and related educational fees and expenses.
Certain medical expenses.
Costs related to purchasing a principal residence.
It is important to note, that if you are considering filing for bankruptcy – you probably should not tap your retirement accounts. There is a little known rule, which protects your 401K from creditors. Other retirement accounts, such as 403B plans – which are not set up under ERISA – do not have these protections, which makes your 401K a unique asset. IRAs, while not protected under ERISA, have a degree of protection under federal bankruptcy laws.
There is probably an even less known rule, The Rule of 55. If you lose your job, for any reason (even voluntarily) and you are over the age of 55 – you may withdraw funds from your 401K or your 403B – without the 10% penalty. This rule does not apply to IRAs or 401K/403B plans from previous employers, and, in order to qualify for this favorable treatment, you must have turned age 55 prior to leaving your employer.
While the 7 reasons listed above would qualify you to take a withdrawal from their 401K – they do not exempt you from paying income taxes on the funds you withdraw. And remember, your 401K plan is meant for saving money for your retirement years, so there is a 10% penalty on withdrawals prior to age 59 ½ to discourage accessing these assets. However, the 10% penalty is waived if:
You become totally disabled.
Your medical debt expenses exceed 7.5% of your Adjusted Gross Income.
Withdrawal is due to a court order as part of a divorce settlement
The Rule of 55, as explained above, or
You are separated from service and have set up a withdrawal schedule of equal periodic payments over the course of your life expectancy.
As part of the economic relief package due to Coronavirus, Congress allows Americans to take a Coronavirus Related Distribution (CRD) of up to $100,000 from their retirement savings – including 401K plans and IRAs – without the typical 10% penalty. You would still have to pay taxes on the withdrawal, however – you may do so over a 3 year period, or you may pay back the withdrawal amount, and not owe any taxes at all. So far, Coronavirus Related Distributions are available only in 2020, and not all retirement plan sponsors offer it, because the new law is penned as an optional plan feature, rather than a strict rule.
Ultimately, should you be considering an early withdrawal from your company retirement plan, we recommend that you consult with your and tax advisor, such as a CPA, prior to doing so. As you can see from the discussion above, the rules are complex and changing all the time. A quick visit or phone call with your CPA may save you heartache at tax time.
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