401(k) Plan Hardship Withdrawals vs. Participant Loans

It can happen to anyone at any time. An unexpected major expense arises, and retirement savings are the only option for handling it. When facing financial difficulties, individuals with 401(k) plans may consider either taking a hardship withdrawal or a loan from their retirement accounts. However, before making a decision, it is important to understand the key differences and potential implications of each option.

Hardship Withdrawals

Starting in 2025, as a result of the SECURE 2.0 Act, and if their plan allows it, individuals can take a penalty-free distribution of up to $1,000 per year for emergency expenses, which are defined as “unforeseeable or immediate financial needs relating to personal or family emergency expenses.” There is no early withdrawal penalty, but the individual will be subject to income taxes and must repay the distribution within three years. Further, no additional withdrawals will be permitted until the distribution is fully repaid.

However, what if $1,000 is not enough, or if an individual’s plan does not offer this new provision? If he/she has an “immediate and heavy financial need,” as defined by the Internal Revenue Service (IRS), a hardship withdrawal may be an option. The IRS considers the following to be qualifying expenses for hardship withdrawals:

• Medical expenses
• Costs related to the purchase of a principal residence
• Tuition and related educational fees and expenses
• Payments necessary to prevent eviction or foreclosure
• Funeral expenses
• Certain expenses for the repair of damage to your principal residence

Given that the above situations are foreseeable or voluntary in nature, the participant will need to prove to their employer that they could not have met the financial need using regular pay, an insurance payout, or asset sales. In addition, the individual will be allowed to withdraw only enough to meet the need, plus any applicable taxes and/or penalties. Hardship withdrawals do not have to be repaid; however, any unused funds cannot be rolled over into an IRA. As a result, there is a significant impact on savings. Taking such a withdrawal not only decreases the savings in the participant’s retirement account, but it also weakens their portfolio’s ability to generate future returns, as every dollar taken out of retirement savings today will not be able to generate potential returns in the future.

See IRS FAQs for further guidance on hardship withdrawals.

Participant Loans

If a hardship withdrawal does not seem like a viable option for an individual, taking out a 401(k) loan may be. If their plan allows loans, participants may borrow up to the IRS limit of 50% of their account balance or $50,000, whichever is less (the plan document will stipulate the exact provisions, including repayment terms, interest rates, minimum loan amount, etc.). With a 401(k) loan, the individual essentially repays himself/herself over a specified period, with interest. Most plans generally have a repayment period of five years, but it could be longer if the loan is being used to pay for a primary residence. Loans do avoid taxes and penalties if repaid, but if a participant leaves their job before the loan is fully paid, he/she may be required to pay the outstanding balance immediately. If payment is not made, the IRS could treat the unpaid portion as an early distribution, which would trigger income taxes and a 10% penalty.

Click here for further IRS guidance on participant loans.

If an individual is facing financial hardship, he/she should consider consulting with a financial advisor to determine the best course of action for their specific situation. While tapping into retirement savings can provide short-term relief, it can also have long-term financial consequences in the future.

Please contact us if you have questions about the information outlined above; our seasoned and experienced employee benefit plan professionals are here to help. You can also learn more on our Employee Benefit Plan services page.

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