A plan provider may allow hardship distributions for employees that are experiencing financial need. Before you take one of these distributions, consider the following effects of your withdrawal:
- You probably have to pay income taxes on your withdrawal in the current tax year.
- In addition, you may have to pay an additional 10% early withdrawal penalty unless a special exception applies.
- These amounts will immediately reduce your retirement account balance, and you’ll also miss out on the tax-deferred growth of the withdrawn amount.
Consider the Tax Burden
You should calculate how much your distribution will go towards taxes before you take a hardship distribution. Compare this costs to your other options, such as obtaining a home equity loan or selling assets to get the money you need.
For example, if you’re in the 22% federal income tax bracket, and your withdrawal doesn’t qualify for a special exception, you’ll end up paying 32% of the distribution back in taxes. This doesn’t account for any state income taxes you may owe.
Since you may already be experiencing financial difficulties, this large tax bill may go unpaid, leading to further tax problems. You may be charged late payment penalties and interest, resulting in an ever-growing IRS tax debt balance.
Exceptions to the Early Withdrawal Penalty
Some withdrawals are excepted from the 10% early withdrawal penalty. You may still need to pay income taxes on these withdrawals, and your retirement savings will still be reduced.
The exceptions for 401(k) and other qualified plans include:
- Withdrawals after the employee has become totally and permanently disabled
- Withdrawals to an alternate payee under a Qualified Domestic Relations Order
- Withdrawals for certain unreimbursed medical expenses
- Withdrawals made after separation from service during or after the year the employee reaches age 55, or age 50 if a qualified public safety employee
Some other exceptions also apply, but make sure your withdrawal is eligible for an exception before you take it. Different rules apply to IRAs, which have some additional exceptions, but don’t have all of the exceptions that apply to 401(k) plans.
If you’re experiencing tax problems as you head towards retirement, consult with a tax resolution attorney to discuss your options for reducing or paying off your tax debt.
Contact The Gartzman Law Firm to speak with an Atlanta tax attorney about your case. Request your consultation by calling (770) 939-7710.