What Is a Hardship Withdrawal?

Tax Professionals' Resource
July 12, 2012 — 1,714 views  
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The economy has been troublesome for many people, and you might be able to help clients by explaining the benefits of hardship withdrawals. This option allows consumers to receive funds from a 401(k) plan, but may be difficult to obtain.

How do hardship withdrawals work?

When a client sets up a 401(k), he or she intends to use the funds for retirement. However, unforeseen financial circumstances could put a person in an economic bind, and this may persuade him or her to examine the benefits of hardship distribution.

There are several factors you should consider before offering this option to clients. The Internal Revenue Service (IRS) puts a steep penalty on such transactions, as consumers are subject to 10 percent withdrawal penalties if they are under the age of 59 1/2.

Take the time to discuss your client's financial situation if it is critical, as it could help him or her make the best decision for the present and future. Clients who have unreimbursed medical expenses, high student loans or educational costs and other excessive financial debts are often the best candidates to qualify for hardship withdrawals.

How does a participant qualify?

Clients will need to contact their employers to put this process into motion. Companies can complete these transactions when they receive a proof of need from workers or self-certification.

A proof of need is used less frequently, as it requires employees to disclose information about their financial situations to employers. Meanwhile, self-certification is less invasive, but prevents staff members from making new 401(k) contributions for six months after completing the withdrawal.

Encourage clients to contact their 401(k) plan administrators to find out which method their companies use to begin this process.

The pros and cons of hardship withdrawals

Financial stress might lead your customers to make quick decisions. If you encourage them to look at the short- and long-term effects of such a choice, your clients can be better equipped to make the best selection for their situations.

For example, many might notice the immediate resources they'll have available when they receive the 401(k) funds, but they should examine the long-term ramifications of such a decision. Clients will have less money available when they retire, which can make a substantial difference later in life.

Providing an in-depth explanation about hardship withdrawals is a great place to start when helping clients evaluate their finances. 

Tax Professionals' Resource