Dissecting the 401k Hardship Rule

When it comes to accessing money quickly, there are often only a few sources: your personal bank account, maybe a rainy day fund, or perhaps the place where most have accumulated the most of their assets: your retirement account.

Most know that their nest eggs should be the last place for a 401k hardship withdrawal, but it is often the last untapped source when savers feel financial pain. Your credit cards or consumer loans may be maxed, or you may not have enough equity in your home to get an additional HELOC. A 401k hardship withdrawal may be your last shot at catching up…but is it?

What is the 401k Hardship Rule?

The 401k hardship rule is designed to keep savers from tapping their retirement account whenever they need a spare dollar, or using it as a tax-avoidance method. If you know you’re going to earn less next year, you could contribute more to a 401k, avoid taxes temporarily, and withdraw when your earn less and fall in a small tax bracket.

The 401k hardship rule is also intended to provide access to funds on a need-only basis for certain events that cause financial hardship. Without the 401k hardship rule, you might instead save elsewhere, since the inability to access your cash when you want it doesn’t provide for the financial flexibility modern life necessitates.

Hardship as defined by the IRS includes: medical expenses exceeding 7.5% of adjusted gross income, tuition payments for anyone in your immediate family, payments to avoid home foreclosure or bankruptcy, death benefits for funeral and burial, catastrophic damage to your live-in home, or the purchase of a home (with some restrictions.)

To avoid the 10-percent 401k early withdrawal penalty, you must be medically disabled (unable to work), owe sufficiently on medical bills, have lost your job at 55-years old or older, or have been recently involved in a divorce that requires the division of retirement savings.

Reaching a 401k Hardship Withdrawal

The simple fact of the matter is that most people will, at some point in their life, be considered to be in financial hardship. In fact, with the divorce rate rising to some 50% of all marriages, the sheer number of divorcee hardships is surely bloating the 401k hardship withdrawal numbers even more.

Those most prone to financial hardship are those who have little or no health insurance and have been involved in an accident or have recently become sick. While the IRS suggests that a medical bill must reach 7.5% of annual earnings, those with catastrophic medical insurance policies are very likely to reach this threshold.

An insurance policy with a $5,000 deductible, for example, would trigger the hardship clause for anyone with an income of less than $66,000, which is more than half of working-class America. Unfortunately, those most likely to have such high-risk insurance policies are in the lowest income brackets.

Others may reach financial hardship status without much spending at all. As stated above, the threshold for financial hardship is met by most with high-deductible insurance policies as the cost of health care easily exceeds 7.5% of AGI for uninsured and under-insured savers. Those with such policies have almost free reign to access of their 401k, and they can use it when necessary to shore up any health-related financial pitfalls.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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