Why & How To Avoid A Financial Hardship Withdrawal From Your 401(K)

If you look at your balance sheet, there’s a fair chance that if you have an employer-sponsored retirement plan, it’s one of your largest assets. This can lead many people to view their retirement plan as a resource when it comes to major financial hardships. This is a discussion of why a retirement plan should be a last resort when it comes to financial hardships, how to reduce the burden of financial setbacks, and other ways to fund this need.

Why Should A Hardship Withdrawal Be A Last Resort?

I’m going to use a hypothetical 35-year-old single investor named Conner to discuss this point. Conner makes $85,000 per year and has a 401(k) worth $100,000 today and experiences a serious hardship. His home burns down in a fire and he doesn’t have any insurance to repair/replace the home or his belongings. He withdraws the entire $100,000 from the 401(k) and uses it to rebuild his home.

What are the consequences of this?

1. His federal marginal tax bracket would increase from 22% to 32%.
2. If he lives in a state with state income tax, that bracket would also likely increase.
3. This hardship would be subject to an additional 10% tax penalty. (Exceptions are here).
4. He would lose out on years of compounding interest in his account. If he left the $100,000 invested and received a hypothetical* 10% annual return, it would be worth $1,744,940.23 by his age 65.

So, Conner ends up with around half of his invested amount and is set severely behind for his future retirement goals.

How To Reduce The Burden Of A Financial Hardship

Two major things you can do to minimize the impact financial hardships are maintaining adequate emergency funds and having sufficient insurance for various risks you face.

In Conner’s case, his financial setback could have been completely avoided if he’d had adequate fire insurance coverage. The intention of insurance contracts is to reduce the financial burden of accidental losses. Some other major financial hardships that could be resolved with adequate insurance coverage are:

• The death of a family’s breadwinner (life insurance).
• Inability to continue to work or care for yourself (disability income and/or long-term care insurance).
• A major illness or injury for you or a dependent (adequate health insurance coverage).
• Losses resulting from a car accident (adequate car insurance coverage).
• Lawsuit following an injury on your property (homeowner’s insurance and umbrella coverage).
• Lawsuit for professional recommendations you’ve given (Errors and Omissions insurance).

While in Conner’s case, an adequate emergency fund would have been unlikely to cover the full financial hardship, an emergency fund can often be effective in giving some time, options, and short-term liquidity. Conner should have had an emergency fund of 3-6 months of his expenses.

If his monthly expenses were $4,000 per month and he had a 6-month emergency reserve, he would have had $24,000 on hand to cover some of the most pressing expenses, like securing housing and taking care of some of his essential needs. This would have also significantly reduced the amount he needed to take from the 401(k), thus reducing taxes and fines, as well as allowing some of the funds to continue getting those compounding returns.

Other Ways To Fund A Financial Hardship

If you’re currently experiencing a financial hardship, it’s too late to gain insurance coverage or build up an adequate emergency fund for the setback that has already occurred, (but you can put these in place for future unexpected events).

If you have any funds in a bank account or a non-retirement account, dipping into those is preferable to touching your retirement account.

If you are truly experiencing a financial hardship that you are unable to pay for, there’s a chance that one of the existing government programs covers your hardship for temporary relief.

In Conner’s case, he may be able to get a loan from a family member or bank that would have a lesser financial impact than a hardship distribution from his 401(k).

Lastly, those with loan options on their 401(k)s can opt to take a 401(k) loan as opposed to a hardship distribution. Conner would have been able to take a loan of 50% of his balance up to $50,000. If the loan is paid back on schedule, you would avoid the taxes and penalties, but you would have lost out on some of the compounding returns along the way. I mention this last because in practice, I see this option go in the same way as hardship withdrawals too often. Many investors forget to pay these loans back and must pay taxes and penalties whenever the IRS catches it, which could end up being a financial hardship in itself if it is a surprise.

Conclusion

Financial hardships can be potentially devastating both presently and on your future self if treated improperly. To minimize the impact of financial hardships, consider reassessing your insurance coverage for various risks and building up an emergency fund. If you experience an unexpected financial hardship, consider dipping into non-retirement accounts, assessing your eligibility for government programs, and gaining a loan to cover the temporary need before dipping into your retirement account.

* This hypothetical example is not indicative of the actual performance of any particular investment, insurance contract, or other financial product. This example does not take into account the impact of any market losses or applicable fees and expenses.

This informational and educational article does not offer or constitute, and should not be relied upon, as tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services.

Cicely Jones (CA Insurance Lic. #:0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-5727620.1(10/23)(exp.10/25)