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It just got easier to take money out of your 401(k) or 403(b) retirement plan. The Internal Revenue Service has issued final rules on hardship withdrawals that spell out a host of changes meant to cut down on red tape. Some are mandatory—employers must make the changes as of Jan. 1, 2020, and other are optional. So, how lenient your retirement plan rules are still depends in part on your employer.
Ideally you want to leave your 401(k) alone until retirement. If you’re under 59 ½, you’ll owe income taxes on withdrawals and also a 10% penalty unless you meet certain exceptions like being disabled or in debt for medical expenses that exceed 7.5% of your adjusted gross income.
But what if you really need the cash? First consider options other than a hardship withdrawal. If you have a Roth IRA, you can always withdraw the money you’ve contributed penalty-free and tax-free. The next choice would be to consider a 401(k) loan. You can borrow up to $50,000, or half the balance in your account, whichever is less. Then you end up paying it back to yourself (your 401(k)) with interest. That means you avoid the tax hit and preserve your retirement funds. Watch out if you leave your employer: You’ll have to pay it back by October, the due date of your tax return on extension, of the year after you take out the loan.)
With a hardship withdrawal, you can’t repay the money to avoid a tax hit, so you’ve permanently taken the money out of the tax-advantaged retirement system. The threshold for taking a hardship withdrawal hasn’t changed. You must be facing an “immediate and heavy” financial need, and you can only withdraw an amount to meet that need. Here’s what’s changed.
Disaster-related expenses. The new rules add a seventh category to what automatically counts as a hardship withdrawal: disaster-related expenses of an employee who lived or worked in a federal-declared disaster area. (Note this is not as broad as prior IRS disaster-relief announcements which extended hardship withdrawals to employees taking them on behalf of relatives and dependents.)
The other safe harbor withdrawal categories are: medical expenses, home purchase costs, college costs for the next 12 months, payments to prevent eviction/foreclosure, funeral expenses and home casualty loss repairs.
Most employers use these categories, but they aren’t required to. Some have a catch-all category, so look for that.
The six-month rule. This change is required. It used to be that after taking a hardship distribution, you’d be prohibited from contributing to your 401(k) for the following six months. Now, that six-month suspension rule is eliminated. For hardship distributions taken on or after Jan. 1, 2020, employers must let you get right back to making payroll contributions, so you can build back your 401(k) balance.
The loan-first rule. This change is optional. It used to be that you had to take a plan loan before a hardship withdrawal. Now employers can eliminate that requirement. That makes sense for employees who pretty much know they’re not going to be in a position to pay back a loan.
More sources to tap. This one’s optional too. You used to only be able to access your own contributions—money you stashed away—as hardship withdrawals. Now employers may change their plans to allow you to tap earnings, and qualified nonelective contributions or qualified matching contributions if you have those.
New employee representation requirement. Employers didn’t like figuring out when a distribution is necessary. Now there’s a straightforward three-part test that covers the employer. The employee must first access other employer plan money if available – ESOP dividends and/or deferred compensation. Then, the employee signs off that he or she has insufficient cash or other liquid assets reasonably available, and the plan administrator must sign off that he or she doesn’t have any reason to believe the employee could do without the hardship withdrawal.
The rules for 403(b) retirement plans are generally the same as 401(k)s. One difference is that earnings can’t be distributed as part of a hardship withdrawal.