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Almost everyone has encountered an unexpected bill or financial crisis. Perhaps you received an unexpected bill for a car repair or medical procedure, or perhaps your partner lost their job. Whatever it is, you must find the funds to purchase it.
However, a lot of people lack the savings necessary to cover unforeseen costs. The good news is that you may have a 401(k) hardship withdrawal option available to you if you have one to help you weather the financial storm.
With a hardship withdrawal from your 401(k), you can sometimes access your retirement funds early without incurring penalties. However, it isn’t always the best option and ought to be used as a last resort.
Navigating the complexities of hardship withdrawals from retirement accounts can be challenging, particularly when it comes to understanding the documentation requirements. While the IRS previously required employees to provide proof of hardship to their employers, recent updates have shifted the landscape. This guide delves into the current regulations, offering clarity on whether you need to show proof of hardship withdrawal and outlining the steps to ensure compliance.
No Documentation Required: Self-Certification Permitted
The IRS has adopted a more flexible approach, allowing employees to self-certify their hardship withdrawals without providing supporting documentation to their employers. This means you are not obligated to present bills or invoices as evidence of your hardship. However, it’s crucial to remember that self-certification doesn’t exempt you from the responsibility of maintaining proper documentation. You are still required to keep records that substantiate your claim of hardship in case of an IRS audit.
Importance of Maintaining Documentation
While you are not required to present documentation upfront, keeping records is essential for ensuring compliance and protecting yourself in the event of an audit. The IRS may request documentation to verify the legitimacy of your hardship withdrawal. Failure to provide supporting evidence could lead to penalties and tax implications.
Documentation Guidelines
The specific documentation requirements may vary depending on the nature of your hardship. However, some general guidelines can help you understand what types of records to keep:
- Medical care: Medical bills, receipts, and insurance statements related to the medical expenses that triggered the hardship withdrawal.
- Purchase of principal residence: Purchase agreement, closing documents, and receipts for expenses related to the purchase of your primary residence.
- Educational payments: Tuition bills, receipts for educational expenses, and enrollment verification from the educational institution.
- Foreclosure/eviction: Foreclosure or eviction notices, receipts for payments made to avoid foreclosure or eviction, and documentation of the date of the purchase or sale agreement.
- Funeral and burial expenses: Funeral or burial invoices, death certificate, and receipts for related expenses.
- Repairs for damage to principal residence: Documentation of the damage, receipts for repair costs, and proof of the date of the casualty loss.
Best Practices for Hardship Withdrawals
To ensure a smooth and compliant hardship withdrawal process, consider these best practices:
- Understand the hardship requirements: Familiarize yourself with the IRS guidelines for qualifying hardship withdrawals.
- Document your hardship: Maintain thorough documentation to support your claim of hardship, even though it is not required to be submitted upfront.
- Consult with a financial advisor: Seek guidance from a financial advisor to understand the potential tax implications and long-term financial impact of a hardship withdrawal.
- Consider alternatives: Explore other options, such as loans or dipping into emergency funds, before resorting to a hardship withdrawal.
While the IRS no longer mandates documentation for hardship withdrawals, maintaining proper records remains crucial. By understanding the current regulations, documentation requirements, and best practices, you can navigate hardship withdrawals effectively and ensure compliance. Remember, consulting with a financial advisor can provide valuable insights and guidance throughout the process.
Tap into your home equity
You can use the equity in your house in a number of ways to pay for an emergency. Here are the three primary options:
- Home equity loan. This is an installment loan secured by your home. For the predetermined loan term, you will borrow a lump sum of money and make fixed payments at a fixed interest rate.
- Home equity line of credit. You can borrow against your home equity with a HELOC as well, but it functions more like a credit card than an installment loan. During the draw period, you will have a credit limit that you can borrow up to at any time.
- Cash-out refinance: This loan completely replaces your mortgage because it is a refinance. In contrast to other refinance loans, though, you will borrow more money than the remaining amount and receive the cash difference.
The ability to use the funds for any purpose is one of the three options’ major advantages. Furthermore, because the loan is secured by your home, interest rates are typically lower.
However, there is a glaring drawback to them: you are putting your house up for collateral. You run the danger of losing your house if you can’t make your payments.
Cost of a 401(k) hardship withdrawal
You must pay income taxes on your withdrawal unless it comes from a Roth 401(k), which is an account with after-tax contributions. This withdrawal will be taxed similarly to your regular income, which means it will be subject to your regular effective tax rate, which can range from 2010% to 2037.
A hardship withdrawal in many cases will also be subject to the 2010 early withdrawal penalty that the IRS imposes on distributions made before the age of twenty-five percent (C2%BD).
As an illustration, let’s say you need $10,000 to pay for a financial emergency, but you are not exempt from the early withdrawal penalty. Assume, for the purposes of this discussion, that your effective tax rate is 2015. This is your average tax rate. Initially, you would have to pay income taxes in the amount of $1,500, which is 2015% of $10,000, on your withdrawal. You would have to pay an extra $1,000 in order to satisfy the 2010 early withdrawal penalty. Thus, you would have only $7,500 left over after taking out $10,000.
The good news is that the IRS allows for some exemptions from the 2010 early withdrawal penalty. They include:
- Total and permanent disability.
- Payments that are made under a qualified domestic relations order.
- A series of substantially equal periodic payments.
- Unreimbursed medical expenses above a percentage of adjusted gross income.
Remember that even if you are exempt from the 2010 early withdrawal penalty for your hardship withdrawal, you will still be required to pay income taxes on the entire amount.
401k Hardship Withdrawals [What You Need To Know]
FAQ
Do you have to provide receipts for hardship withdrawal?
Can I get in trouble for lying about a hardship withdrawal?
What documentation is acceptable for hardship withdrawal?
Does your employer have to approve a hardship withdrawal?
Can I withdraw from my retirement account if I have a financial hardship?
Some retirement plans, such as 401 (k) and 403 (b) plans, may allow participants to withdraw from their retirement accounts because of a financial hardship, but these withdrawals must follow IRS guidelines. A plan may only make a hardship distribution:
Do employers allow hardship withdrawals?
Employers are not required to allow hardship withdrawals, so access can vary from plan to plan. Contact your plan administrator to see if your plan permits hardship withdrawals. The IRS also says that hardship withdrawals are only an option if you can’t reasonably get money from another source.
Should I use a 401(k) hardship withdrawal?
Use a 401 (k) hardship withdrawal only if it is your last option. To qualify as a hardship, you will need to make your case to your 401 (k) plan administrator. Most of the time, they can easily figure out wherther your circumstances qualify as a hardship. Some 401 (k) plans may require you to present some form of documentation.
How do I apply for a 401(k) hardship withdrawal?
You may be able to apply online or in person for a 401 (k) hardship withdrawal through your 401 (k) plan sponsor — such as Vanguard or Fidelity — or your employer. While the IRS manages the policies and rules around hardship withdrawals, individual plan sponsors/employers have their own policies.