The most important account in your financial plan is your emergency fund.
Yet, your emergency fund isn’t always enough to protect you in an unexpected time of need. In those situations you may need to resort to alternative sources.
One common source to access is an IRA or 401(k). Especially for you because of your mastered How Much I need to Save. This has allowed you to accumulate a nice balance in your 401(K) and IRA. Now that you’re in an emergency situation the balance in those accounts would come in useful now.
A 401(k) and Traditional IRA was created to defer taxable income earned now for your use when you retire. Because of that trade-off and to nudge good behavior, restrictions were created to minimize access to that money prior to age 59 1/2. Although there are a few exceptions to that rule.
When it comes to your 401(k), 403(b), or 457(b) you can only access this money when you meet what is called an immediate and heavy financial need. Alternatively called a hardship. On the other hand, your IRA doesn’t have any hardship requirements. You can access that money any time.
Whenever you take money out of your IRA, 401(k), 403(b), or 457(b) the money is considered taxable income. Hence, the reason you get a tax deferral when you put money into those accounts. It doesn’t matter how old you are or how long you’ve had the account. You will pay ordinary income tax on a distribution from these accounts.
In addition to the income tax due on distribution you may owe a penalty if you take the money out of those accounts prior to reaching age 59 1/2.
Let’s break this down.
What is considered a hardship withdrawal?
A hardship withdrawal is defined by the IRS as an immediate and heavy financial need. Thankfully this broad definition can be outlined with specific needs that meet this eligibility:
- Un-reimbursed medical expenses for you, your spouse, or dependents. Most importantly, this means medical expenses in excess of 10% of your AGI!
- To cover costs directly related to the purchase of a principal residence for the employee. This does NOT include mortgage payments.
- To prevent foreclosure or eviction from your principal residence
- Certain expenses for the repair of damage to your personal residence that would qualify for the casualty deduction. Similar theory as medical expenses. Be careful!
- College tuition or related educational expenses for you, your spouse, or children. Only covering the next 12 months of post-secondary education.
- Funeral expenses
The above list is not a requirement for all 401(k), 403(b), and 457(b) plans to accept those hardship requests. Therefore, check with your plan administrator or in-house human resources representative for clarification on what is an eligible hardship for your specific plan.
In fact, you may need to prove to your employer that you don’t have any other resources available to meet the need. Your vacation home could be that resource that makes you ineligible for the hardship distribution.
Limitations of a hardship withdrawal
The amount you are eligible to take for a hardship withdrawal is limited to your contributions. No interest earned or employer contributions are eligible.
Once you take your hardship withdrawal you’re suspended from making any further contributions for 6 months.
You will need to have evidence supporting your request for a hardship withdrawal.
Supporting evidence must match the period of the withdrawal too. If the period of your hardship/exception and the early distribution don’t match, then the IRS could disallow the exception leaving you subject to the penalty.
You wouldn’t do this anyway, but if you thought about taking an early distribution for a boat or a car then you would be denied the hardship withdrawal and be subject to the 10% penalty.
Remember, if you have a Traditional IRA the hardship withdrawal rules don’t apply. There are no restraints on the reasons to take money out of your IRA.
Hardship Withdrawal and the Early Distribution Penalty.
A common misconception is that if you meet the hardship withdrawal requirement you will not be subject to the 10% early distribution. Unfortunately these are not the same thing!
Yes, there is crossover, but you need to read this before you make the wrong decision.
What is critical to remember is that there are only exceptions to the penalty. There are NO exceptions to paying ordinary income tax on the distribution. See the example in the next section for this calculation.
If you take money out of your 401(k), 403(b), 457(a), or Traditional IRA before you’re 59 1/2 here are your exceptions against the 10% penalty:
- Un-reimbursed medical expenses in excess of 10% of your AGI
- To pay the IRS for a levy against your account
- Total and permanent disability
- Qualified higher education expenses (IRA ONLY)
- First-time homebuyers up to $10,000 (IRA ONLY)
- Health Insurance Premiums paid while unemployed (IRA ONLY)
- Military qualified reservists called to active duty
- Distributions rolled into an IRA
- Distributions after the death of the account holder
- Substantially equal periodic payments after separation from service
- After separation from service, age 55 (50 if government plan)
- Not eligible with a SEP or Traditional IRA
- Transfer under a qualified domestic relations order
The list is fairly long and a deeper look at some of these is more complicated. Because of that seek out your trusted advisor to understand if these exceptions apply to your personal situation.
Now that you know the exceptions to the penalty let’s put some numbers to it for a better illustration.
Tax Impacts of an early distribution
Whether your money is sitting in an IRA, 401(k), 403(b), or 457(b) by taking money out of those accounts prior to 59 1/2 you are subject ordinary income tax. If you do not meet an exception you are also subject to the 10% early withdrawal penalty.
Example 1: Jim, age 49, takes $10,000 out of his retirement account. Jim is in the 15% tax bracket. His total tax and penalty will be $2,500 ($1,000 penalty + $1,500 tax). This means the $10,000 he wanted will only be $7,500 in real dollars. Although, if he lived in a state with income tax then this number is even smaller!
Example 2: Jill, age 47, takes $10,000 out of her retirement account. Jill is in the 15% tax bracket. Jill used this money for un-reimbursed medical expenses. Her AGI is $50,000; therefore, her deductible medical expenses totals $5,000 (AGI-$50,000 multiplied by 10% threshold). Money in excess of the medical expense threshold is $5,000 ($10,000 distribution minus $5,000 deductible medical expenses). Her total tax is $1,500 ($500 penalty + $1,500 tax). She’s left with $8,500 assuming no state income tax.
As you can see an early distribution may not be a favorable solution. Considering other options prior to accessing this money prior to age 59 1/2 is definitely advised.
Options to consider first
When times are tough, don’t make them tougher by defaulting to an early withdrawal because it’s perceived as easy to access. Consider all of your other options first. A few ideas to try before considering an early withdrawal from your 401(k) or Traditional IRA:
- Utilize the 401(k) loan feature if your plan allows it
- Take out a personal loan
- Tap your 529 College Savings Plan first
- Earnings are subject to tax and penalty
- Contributions are penalty free
- Roth IRA contributions
The early distribution rules are complex and unfavorable. I hope you are never in a situation to need money in an emergency like this. If you are please consider talking with a qualified advisor before making this decision.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.