Brian O'Connell
Jul 17, 2024
“There are times when potential debt is unavoidable, and that’s simply life," said Anthony DeLuca, a certified financial planner at RetireGuide.com in Longwood, Florida, in an email. "That’s why certain hardship withdrawals are the correct move to avoid debt, even if it means your retirement plan takes a step backward.”
Rising household costs are leading many Americans to borrow from their retirement accounts to prevent foreclosure on their homes. Hardship withdrawals, though helpful in emergencies, come with tax penalties and may hinder long-term financial goals. Building an emergency fund can help avoid the need for these withdrawals.
According to a recent Vanguard report, 3.6% of American retirement savers used their 401(k) plans to cover significant household shortfalls in 2023, up from 2.8% the previous year. Home foreclosures were the biggest reason for these withdrawals, accounting for 39% in 2023, up from 31% in 2021.
“There are times when potential debt is unavoidable, and that’s simply life," said Anthony DeLuca, a certified financial planner at RetireGuide.com. "That’s why certain hardship withdrawals are the correct move to avoid debt, even if it means your retirement plan takes a step backward.”
A hardship withdrawal is taking money from a retirement account for personal financial expenses. These withdrawals are meant to cover immediate and heavy financial burdens, such as medical care, funeral expenses, eviction prevention, and certain home repairs. Christian Mundy from LifeLine Wealth Management emphasized that the withdrawal amount is limited to the need, and other funds cannot cover such expenses.
“Always know this withdrawal is not a loan,” DeLuca said. “When the money is out, it’s out for good.” Additionally, these withdrawals are taxed at one's ordinary income bracket and incur a 10% penalty if under 59 1/2.
The IRS allows penalty-free withdrawals in certain situations, like medical expenses over 7.5% of one's adjusted gross income, permanent disability, or separation from service after age 55. There’s also an annual $1,000 emergency withdrawal provision without penalty, though taxes still apply if the loan isn't repaid.
Pros of hardship withdrawals include covering unexpected financial burdens without going into debt. However, they reduce retirement progression and growth potential, possibly requiring increased contributions and longer working years.
Good reasons to take a hardship loan include significant medical expenses, preventing foreclosure or eviction, and funeral expenses for loved ones. In some cases, it can also help with down payments on primary residences or repairs due to natural disasters.
“Try exploring other options, such as loan modification or refinancing, before tapping into your retirement savings,” advised Glen Hedrick from Old North State Wealth Management.
To recover after a hardship payout, increase paycheck contributions sustainably and utilize catch-up contributions if over 50.
To avoid retirement hardship withdrawals, build an emergency savings account. Aim for one to two months of gross monthly income for spending shocks and $15,000 to $20,000 for income loss. Consistent contributions to an interest-earning savings account can achieve this over time.
In financial emergencies, consider Roth IRA withdrawals first, as contributions can be withdrawn without penalties or taxes. “With a Roth IRA, you can withdraw any of your contributions without penalties or taxes, (but) just the money you contributed, no earnings,” said Kendall Meade, a financial planner at SoFi.