Personal Finance - Arla Wallace
Arla Wallace is an accounting professional with over 20 years experience. She spent several years working for both publicly-traded and private entities before founding her own business. Today she partners with small business owners so they can focus on operations while leaving the responsibility of staying on top of accounting tasks to her. She is a Certified Public Accountant (CPA) and a Certified ProAdvisor for Quickbooks Online.

Retirement Savings Plans: Loans and Hardship Withdrawals

Retirement Savings Plans: Loans and Hardship Withdrawals

Employer sponsored retirement savings plans enable plan participants to contribute a portion of wages to an individual account. Distributions are included in taxable income at retirement. But did you know that some qualified retirement plans permit withdrawals for loans and hardships during the working years? As both expected and unexpected life events can put a strain on an individual’s financial situation, retirement plan loans and hardship withdrawals may be available to provide the necessary monetary relief when borrowing funds from another source is not an option.

Loans

Provided a qualified 401(k) or 403(b) plan is set up to a permit them, participants may take out loans from their retirement savings plan. Similar to conventional bank loans, a loan from a qualified retirement plan must be paid back, including both principal and interest. However, unlike a bank loan, the interest is paid back to the retirement account and not to a bank. The maximum loan amount a qualified plan can permit is the lesser of $50,000 or 50 percent of the vested account balance. There is an exception to this rule, for vested account balances lower than $10,000, if permitted by the plan. In that case, the participant may borrow up to $10,000.

These plan loans are not subject to hardship qualification; therefore, neither the purpose for taking out a loan nor the participant’s credit worthiness are used in the loan decision. Loans from a qualified plan must be paid back within five years, with repayments made at least quarterly. An exception to the repayment timeline is loans taken out for the purpose of purchasing a principal residence, which may allow repayment over a period of more than five years. 

It is possible to have more than one outstanding loan from a single plan. However, a new loan, when added to the outstanding loan balance from a previous loan, cannot exceed the plan maximum amount during a 12-month period ending on the day before the new loan is made. A loan is not taxable unless it is not paid back according to its specific repayment terms. If the loan is not repaid in accordance with its terms, it is treated as a distribution from a qualified plan and would be taxable.  

Hardship Withdrawals

Retirement plans may allow plan participants to receive hardship distributions. Unlike plan loans, hardship distributions must meet two criteria: (i) an immediate and heavy financial need; and (ii) an amount limited to satisfy that financial need. The retirement plan’s sponsor determines the need based on the plan terms coupled with all relevant facts. Hardship withdrawals are subject to income taxes (unless they contain Roth contributions). Furthermore, hardship withdrawals cannot be repaid to the retirement plan nor rolled over to another plan or IRA, and may also be subject to the additional 10% tax on early distributions.

Under IRS regulations, an employee participant is automatically determined to have an immediate and heavy financial need if the withdrawal is for one of the six types of “safe harbor” distributions. These safe harbor distributions include: (i) medical care for the employee, spouse, and dependents; (ii) costs associated with the purchase of a principal residence; (iii) post-secondary school tuition and expenses for the employee, spouse, and dependents; (iv) payments made to prevent eviction from the employee’s principal residence or foreclosure of such residence; (v) funeral expenses for the employee, spouse, or dependents; and (vi) certain expenses incurred to repair damage to the employee’s principal residence.

Keep in mind that any hardship distributions permanently reduce the amount of funds available to you in your retirement account, so consider all of your options before going this route.