If cracking your nest egg seems like the answer to higher consumer costs, the return of student loan payments and rising interest rates, you're not alone—but you may want to think twice.
A recent survey found that 36% more people took hardship withdrawals from their 401(k)s in the second quarter of 2023, compared to the second quarter of 2022. Even within this year, the number of withdrawals has risen 12% from the first quarter to the second. The average withdrawal hovered around $5,000 for the first two quarters of 2023, the survey found.
And it's not just young people with time to save who are taking from their retirement to fund their current financial emergencies. While 28% of Gen Z and 24% of millennials have taken a hardship withdrawal, 19% of Gen X, and 12% of boomers—who are much closer to retirement age—are also doing it.
It's not that these people don't know that saving for retirement is important, it's that they feel like they have no other options, experts said.
"Most participants only take withdrawals from their retirement plans if they are in financial distress. Current economic stress is likely the contributing factor. Maybe they are behind in their mortgage or rent, or they have too much credit card and student loan debt, or it could be because of higher inflation—they just don't have enough money to cover the monthly bills."- Brandy Marion, institutional wealth education manager at BOK Financial®
Marion is also seeing more people take out hardship withdrawals because of major damage to their homes from natural disasters like tornadoes or forest fires. "With the change in our climate and our storms becoming more violent, I believe we will see more of these types of distributions," she said.
What is a hardship withdrawal?
"A hardship withdrawal is a distribution that allows you to take money out of your 401(k) for special circumstances like buying a home or paying for a funeral," said Marion. "But there is a downside—unlike a 401(k) loan, you don't have to repay hardship withdrawal. And it comes with financial implications, including penalties and taxes."
Remember, a 401(k) plan is designed to help you save money for retirement, and the IRS cautions against dipping into yours. But it is allowable under certain conditions. According to the IRS, 401(k) hardship withdrawals are allowed only for "immediate and heavy" financial needs.
Qualified expenses include:
- Medical care or funeral expenses for you, your spouse, dependents or beneficiary.
- Costs directly related to the purchase of your principal residence (excluding mortgage payments).
- Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for you, your spouse, dependents or beneficiary.
- Home costs including eviction or foreclosure prevention and certain damage expenses.
To receive the money, you must provide a letter stating that:
- The distribution is limited to the amount of the "immediate and heavy" financial need, and
- You couldn't reasonably obtain the funds from another source.
What are the downsides of a hardship withdrawal?
Taxes. Unlike a 401(k) loan, a hardship withdrawal is considered to be taxable income. By law, 401(k) recordkeepers must withhold 20% for the IRS and potentially more for the state if it withholds, meaning a larger initial withdrawal. For example, if you need $8,000 for your emergency, you must take $10,000 out of your retirement to cover the taxes.
If you're younger than 59½ when you take your hardship withdrawal, you may also have to pay an additional 10% early distribution tax.
Depending on the amount, a distribution could push you into a higher income tax bracket, causing you to pay a higher tax rate. In that scenario, the initial 20% sent to the IRS may not cover the taxes owed, and you'll have to pay more when you file for the year.
Savings implications.Besides the initial taxes, you'll also have some long-term repercussions if you take a withdrawal. "If you raid your 401(k), you'll have less retirement savings," said Marion. "To make it up, you'll have to save more or delay retirement."
Marion also warns a withdrawal may impact your allocation—that is, how your 401(k) is invested. "If you have less time to earn money on your retirement fund, you might have to become more aggressive with your investments which could mean more volatility in your asset allocation, leaving you at risk of seeing a loss in your account."
What to do instead of taking a hardship withdrawal
According to Marion, taking a distribution should be the last resort. However, she understands that many people need help through their short-term financial challenges that can't be covered by their emergency fund. She offers seven alternatives for accessing money in an emergency instead of taking a hardship withdrawal:
1. Borrow a pot of money: Can you ask friends or family for support covering your expenses until you can get caught up?
2. Take out a personal loan: While interest will still be accrued, a personal loan won't have the negative implications for your future that come with a hardship withdrawal from your retirement fund.
3. Use a credit card: Make sure you have a plan only to charge what you genuinely need, or you'll be back in the same financial emergency again.
4. Take on an extra job: Is there a side hustle you can pick up to supplement your income?
5. Sell any assets outside of the 401(k): Consider selling belongings like bicycles, jewelry or clothing.
6. Advocate for a pay raise: Now might be the time to take action if you haven't recently asked for a raise at work. This advice is especially true for women, who tend to make less than their male counterparts.
7. If you must access your retirement savings, take a 401(k) loan instead of a withdrawal. A 401(k) loan allows you to access your retirement fund without taxation or penalties. "You must pay back 401(k) loans with interest," said Marion. "However, the interest paid on 401(k) loans usually goes back into your account. In essence, you'll turn a portion of your balance into a fixed account earning a fixed amount of interest."
Your retirement fund can be a tempting source of relief when you're faced with financial strain. However, taking a hardship withdrawal can make your overall financial situation worse in the long run. Marion recommends balancing your long-term financial health with your current wellbeing by protecting your 401(k) and opting for these other cash-flow strategies.
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