Funding a 401(k) account is easy because you automatically contribute a modest percentage of each paycheck, and your investment builds over the long run. During the flurry of the Covid pandemic, the number of people who took money out of their 401(k)s skyrocketed, but now that the pandemic is over, let’s take a look at what is involved for your employees to withdraw money from their 401(k)s.
What is a 401(k) hardship withdrawal?
A hardship withdrawal is when an employee takes money out of their elective 401(k) deferral account because of an immediate and “heavy” financial need, and it is limited to the amount necessary to satisfy that financial need.
For your employees to qualify for 401(k) hardship withdrawals, you must offer a 401(k) plan that permits hardship withdrawals. You are not required to provide hardship withdrawals, so it is your choice to include or not include them in your 401(k) program.
The IRS also says that hardship withdrawals are only an option if they cannot reasonably get money from another source.
You can require a written statement from employees certifying that they cannot pay for financial hardship from other resources, including insurance, liquidation of assets, salary, plan loans, or commercial loans.
Hardship withdrawals are allowed in a limited set of conditions. While an emergency room bill would be considered eligible for a 401(k) hardship withdrawal, a vacation would not.
There are limits on how much money they can take from their 401(k) account in a hardship withdrawal. They can only withdraw the amount you need to cover an immediate need, plus any taxes or penalties.
The IRS permits 401(k) hardship withdrawals only for “immediate and heavy” financial needs. According to the IRS, the withdrawals that qualify include:
- Health care expenses for you, your spouse or a dependent
- Purchase of a principal residence
- Tuition and room and board for yourself, your spouse or a dependent
- Payments to prevent eviction
- Funeral or burial expenses for your spouse or a dependent
- Repairs to your principal residence
- Expenses resulting from a declared disaster
Taxes and Penalties
The amount of the hardship withdrawal will be included in the employee’s annual taxable income. Please note that the distribution could push the employee into a higher income tax bracket, leading them to pay a higher marginal tax rate. In addition, if they are younger than 59½, they may have to pay an additional 10% early distribution tax.
There are some exceptions to the early distribution tax rule that include:
- The plan owner dies or becomes totally and permanently disabled.
- The withdrawal is used to pay for unreimbursed medical expenses (if the amount exceeds a percentage of your adjusted gross income).
- The government waived early withdrawal penalties for distributions up to $100,000 from retirement plans used to pay for expenses related to qualified, federally-declared disasters.
You Will Know When Employee Withdraws From 401(k)
Employees often ask if their employer will know if they withdraw from their 401(k). The short answer is yes — if they make a 401(k) withdrawal, you or someone on your team will know. This is because your company is responsible for all aspects of offering your 401(k) plan. While not a “public record,” those within your company authorized to monitor and maintain the 401(k) plan can see everyone’s contributions and withdrawals. This doesn’t necessarily mean that their immediate boss will know about your withdrawal, but someone in your company will have access to the records.
Alternative to a 401(k) Withdrawal
Taking money out of their 401(k) before retirement should be a last resort. We can include a 401(k) provision that allows employees to borrow up to 50% of their vested balance from their accounts. Employees will pay the principal and interest back into their account, and no taxes or penalties are attached to loan distributions. The loan option is still a last resort because it won’t generate any interest or capital gains on the borrowed money. But avoiding taxes and penalties and paying that money back via the rules of the loan can be a better option than a withdrawal or using a high-interest credit card.
Dealing with financial stress is challenging, especially when you don’t know how to pay for unexpected emergencies. Offering 401(k) hardship withdrawals or loans might be an option for your 401(k) plan. Contact PT Business Solutions. We’ll help you determine the best options for your company’s best 401(K) savings plans.