You may be able to tap your 401(k) in a crisis, but you'll pay a price for it. If your employer's plan allows you withdraw the money, you pay income tax on whatever you take out. With a few exceptions, such as permanent disability, you pay a 10 percent tax penalty as well. In many cases, you'll have to wait to start putting money back into the account, reducing its value for your future.
Proof of Need
The IRS lets you withdraw from your 401(k) on the assumption you're desperate. For example, you have medical or college bills or you're facing foreclosure, and you have no other way to make a payment. If your employer allows hardship withdrawals, he still has to confirm that you really, really need the money. One way to do that is go over your finances in detail and confirm how broke you are. If your employer follows this path, you can keep right on contributing to your 401(k).
Many employers and plan administrators don't want to take time to review your financial records. Instead, your boss can simply take your word for it, unless she knows for a fact that you don't need a hardship withdrawal. This approach saves a lot of paperwork, but it comes at a cost: The plan won't allow you to make elective contributions for at least six months. You also can't contribute to any other accounts you have with your employer. This is evidence that you have a real hardship: If you could keep depositing money, presumably you weren't as desperate as you claimed.
Anything you take out of your 401(k) is going to hurt you. If you withdraw $10,000 for medical bills, for instance, you not only pay tax on the money now, but it's no longer in the account earning you tax-deferred interest. If your account earns an average 6 percent interest over the next 20 years, that $10,000 would have been worth $32,000. You wouldn't have to pay tax on any of that until you started making withdrawals.
If your plan allows you to take out a loan from your 401(k), that may be a good alternative to a hardship withdrawal. In some cases, it's a required alternative: You can't claim hardship until you've borrowed as much as possible from the plan. Unlike a 401(k) withdrawal, the loan doesn't stop you from contributing to the plan and you don't pay income tax on the loan amount. You will, however, have to pay the money back over five years, including interest; if you're facing a real financial hardship, that may not be practical.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.