I'm a CFP: Here's the Real Cost of a Hardship Withdrawal From Your 401(k) -- and Smarter Options
Taking a hardship withdrawal from your 401(k) is not a decision to make lightly. You know this. But your budget is stretched so thin it’s fraying. As your options dwindle, you figure that your 401(k) is your money — so why not use it when you need it most?
Unfortunately, the real cost of a hardship withdrawal goes beyond the dollar amount you take out. It includes taxes and potential penalties, as well as lost investment growth and a significant hit to your long-term retirement savings. What can you do to protect your 401(k) while still navigating financial hardship?
Learn About: 5 Common Impulsive Financial Decisions You'll Regret
Learn More: Start Growing Your Net Worth With Smarter Tracking
To learn more about why you may want to avoid a hardship withdrawal — and which alternatives to explore instead — MoneyLion spoke with Jason Fannon, CFP®, a senior partner at Cornerstone Financial Services.
What Is a Hardship Withdrawal?
First, Fannon wanted to clearly define what a hardship withdrawal means, because it’s not the same as a loan or even a standard early withdrawal.
“A hardship withdrawal is a distribution from the account and cannot be repaid,” Fannon said. “A hardship is defined by the IRS, and common reasons include medical expenses, the purchase of a primary residence, and tuition or other educational expenses.”
He added that these distributions are taxable and may also be subject to a 10% penalty if you’re under age 59½, unless you qualify for an IRS exemption.
Be Mindful of the Taxes
Another factor to consider before taking a hardship withdrawal from your 401(k) is the impact of federal and state taxes, along with possible penalties. Fannon noted that hardship withdrawals are taxed as ordinary income at both the federal and state levels. If the withdrawal doesn’t qualify for an IRS exemption, you could also face a 10% penalty.
“Additionally, the investor loses the ability to compound funds tax-deferred,” Fannon said.
A Real-Life Scenario
To illustrate his point, Fannon offered a hypothetical example of an investor who withdraws $10,000 to cover a medical expense. That withdrawal would be subject to federal and state taxes — here’s what that could look like:
“If the investor is in the 12% marginal tax bracket and lives in Michigan (4.25%), then they would pay $1,200 in federal taxes and $425 in state tax,” Fannon said. “Additionally, if the investor is under age 59½, they may face a penalty of 10%, or $1,000. In this example, $2,625 would go to taxes and penalties, or 26.25%.”
Looking at the math, it’s clear why Fannon advises his clients against hardship withdrawals, instead encouraging them to rely on alternatives like emergency savings when possible.
There Are Alternatives
So what can you do instead of making an early withdrawal and taking on taxes and penalties? Fannon stressed the importance of maintaining a robust emergency fund. MoneyLion also identified a few other potential options:
Personal Loan: This option keeps your retirement funds intact. You may be able to secure fixed payments and predictable terms. However, depending on your credit, interest rates could be high. It also adds to your debt load, so it’s worth careful consideration. This option is best for borrowers with solid credit who want a structured repayment plan.
401(k) Loan (If Your Plan Allows It): If repaid properly, you’re essentially borrowing from yourself — without triggering taxes or penalties. You can typically borrow up to 50% of your vested balance, up to $50,000. However, you’ll need to repay the loan with interest. Be aware that losing your job could trigger immediate repayment or put the loan into default. You’ll also miss out on potential market gains while the money is out of your account. This option is generally best for short-term liquidity needs if you have stable income.
Payment Plans or Hardship Programs: This approach allows you to avoid borrowing altogether. You might explore medical payment plans, utility hardship programs, mortgage forbearance, loan forbearance or modification. These options can preserve your cash and investments, and many offer low or no interest. However, they often require negotiation and may extend your repayment timeline. This is typically a good fit for managing medical debt, utilities or temporary income loss.
So yes, you do have choices beyond a hardship withdrawal. While each comes with pros and cons, they’re generally safer options.
The Bottom Line
If you’ve reached the point where a hardship withdrawal from your 401(k) feels like your only option, you’re not alone. It’s a tough spot to be in. But taking this step could ultimately make your situation more difficult due to taxes and penalties. You’re likely better off exploring alternatives first.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal, or tax advice.
More From MoneyLion:
How Middle-Class Earners Are Quietly Becoming Millionaires — and How You Can, Too
7 Kirkland Signature Items at Costco Worth Buying This Spring
4 Financial Decisions Young Adults Make That Are Hardest To Undo