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401(k) Loan vs. Hardship Withdrawal: What Are the Financial Implications?

Asian couple riding bikes and discussing 401(k) loan vs. hardship withdrawal

A 401(k) can help you set money aside for your retirement, but the balance can be a tempting source of relief when emergencies arise. Before you consider dipping into your retirement money, it's important to learn about the details of a 401(k) loan vs. hardship withdrawal so you understand the potential implications.

Loans and hardship withdrawals can both help give you access to money from your retirement savings. But they could have an impact on your retirement plans. Still, in some situations, there may not be any attractive options and you simply need money. Here's what you should know about when you can take a hardship withdrawal or loan, and what the potential implications are of each.

When You Can Take Hardship Withdrawals

Not all 401(k) plans allow hardship withdrawals. As optional features, they're only available when your employer chooses to include them. To find out if a hardship withdrawal is possible, ask your plan administrator.

If hardship withdrawals are available, you need to qualify before taking one. The IRS requires that you face an "immediate and heavy financial need," according to terms defined by your plan, to satisfy hardship withdrawal requirements. There are several ways to qualify, which can vary. Some examples include:

  • Medical expenses for you or a family member.
  • Costs related to purchasing a primary residence.
  • Tuition and fees for postsecondary education.
  • Payments required to prevent eviction or foreclosure on your primary residence.

Financial Impact of Hardship Withdrawals

You should be aware of several potential consequences of taking a hardship withdrawal.

Taxes owed: According to the IRS, if you withdraw pretax money, you must pay income tax on the amount you receive. Also, if you're under age 59 1/2, you may owe an additional 10 percent penalty tax on your withdrawal unless you qualify for an exception. Exceptions to the early withdrawal tax may include unreimbursed medical payments and certain expenses after terminating an employment when you're 55 or older.

Reduced contributions: Your 401(k) balance drops when you take a withdrawal, and you'll have less money available for spending in retirement. Replenishing your account after receiving a hardship withdrawal can be challenging, especially with annual contributions limits, so be mindful that the withdrawal is really serving a critical need.

When You Can Take a Loan

401(k) loans, like hardship withdrawals, are optional plan features. Some employers choose not to allow loans for their employees. But if your plan offers loans, you can take one whenever you want, and you can use the funds for any purpose. That said, some plans limit loans, and you might only be allowed to have one outstanding loan at a time.

When borrowing from your 401(k), you can take up to 50 percent of your account balance or $50,000 — whichever is less. In most cases, you repay your loan over five years, but longer terms may be available if you use your loan to purchase a primary residence.

How a 401(k) Loan Affects Your Finances

Understanding the trade-offs of borrowing from your account is important.

Opportunity cost: By taking money out of your 401(k), you reduce your invested account balance. As a result, there's less money earning interest, dividends and potential capital gains for your future. That may work out in your favor if investments lose money, but your savings may suffer if those investments gain value while your money is out of the markets. Just keep in mind that no investment type can guarantee growth, and can instead lose value. Past performance also can't guarantee future results.

Potential default: If you can't repay your loan, the IRS treats the amount you took as a distribution. You may have to pay income tax on that amount, and you might also have to pay an additional penalty tax if you're under age 59 1/2.

Cash flow: You need to repay your loan, which could possibly put a strain on your budget, especially if you considered taking a loan as a result of a financial rough patch. While you're making payments to eliminate the debt, it might be harder to save for retirement, which may delay your progress toward retirement goals.

MORE: Does Cashing Out Your 401(k) to Pay Off Debt Make Sense?

Should You Take a Hardship Withdrawal or Loan?

Whenever possible, you may want to leave your retirement savings alone and fund your needs from other sources. Some people like the idea of a 401(k) loan vs. hardship withdrawal because they think the impact is temporary.

If you really need extra money from an additional source now, consider meeting with a financial professional to review the best options for you. Taking a complete look at all of the options available to you may help you understand the various benefits and caveats before making the right choice for your long-term financial goals.

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