Hardship Withdrawal vs. 401(k) Loan: What’s the Difference?

Both have pros and cons, but a loan is usually preferable

Hardship Withdrawal vs. 401(k) Loan: An Overview

Is it ever okay to take from your 401(k) plan, either as a 401(k) loan or a hardship withdrawal? After all, your plan is a powerful retirement savings tool and should be carefully handled. The primary advantage of saving in a 401(k) is the ability to enjoy tax-deferred growth on your investments. When you’re setting aside cash for the long term, a hands-off approach is usually best. Nevertheless, there are some scenarios in which taking money out of your 401(k) can make sense.

Key Takeaways

  • Hardship withdrawals are only allowed when there’s an immediate and heavy financial need, and typically withdrawals are limited to the amount required to fill that need.
  • Under regular IRS guidelines, you can borrow 50% of your vested account balance or $50,000, whichever is less, as a 401(k) loan.
  • If you’re not in dire financial straits but still want to take cash from your 401(k) plan, a loan is usually best.

Hardship Withdrawals

The Internal Revenue Service (IRS) specifies that hardship withdrawals are allowed only when there’s an immediate and heavy financial need, and withdrawals are normally limited to the amount required to fill that need. These withdrawals are subject to ordinary income tax and, if you’re under the age of 59½, there is a 10% early withdrawal penalty.

The IRS offers a safe harbor exception, allowing someone to automatically meet the heavy-need standard if they are in certain situations. For example, a safe harbor exception is allowed for people who need to take a hardship withdrawal to cover medical expenses for themselves, a spouse, or dependents. If you find yourself in a life-or-death medical situation—say, one requiring emergency surgery—taking a hardship withdrawal could help to cover the gap if your insurance coverage falls short.

A hardship withdrawal could also be useful if you experience an extended period of unemployment and don’t have an emergency fund to fall back on. The IRS waives the penalty if you’re unemployed and need to purchase health insurance, although you’d still owe taxes on what you withdraw. Other situations that are covered by the safe harbor exception include: 

  • Tuition, related educational fees, and room-and-board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.
  • Payments are necessary to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage on that residence.
  • Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
  • Certain expenses to repair damage to the employee’s principal residence.

$130,709

The average 401(k) account balance as of Q4 2021.

COVID-19 Hardship Withdrawal for 2020

If you qualify for a Coronavirus-Related Distribution (CRD) from your 401(k) plan during the calendar year 2020, that distribution would have been treated as a safe-harbor distribution not subject to a 10% early withdrawal penalty if you were under 59½, but subject to regular income taxes.

Additional unique stipulations to this special distribution included:

  • The ability to withdraw up to 100% or $100,000 of your account balance, whichever is smaller.
  • The ability to spread out any taxes due over three years.
  • If you pay the funds back into your account within three years, it will be considered a rollover and not subject to taxes.

Other guidelines for eligibility for a hardship withdrawal were amended to include having a job start date delayed or a job offer rescinded due to COVID-19. Those guidelines also allow a spouse of an affected worker to make a hardship withdrawal, even if the spouse is still working.

401(k) Loans

If you’re not in dire financial straits but still want to take cash from your plan, a 401(k) loan is the other option. Under IRS guidelines, you can borrow 50% of your vested account balance or $50,000, whichever is less. A loan, however, has both pros and cons.

For example, a loan is just that—a loan, not a distribution. You’re essentially paying back the money to yourself, which means you’re putting it back into your retirement account, and that’s a positive. Loans are usually repaid with interest, which can make up somewhat for the earnings you’re losing by not leaving the money in your plan.

The downside is that if you leave your job and don't repay the loan within a specified period (just extended to the due date of your federal income tax return, instead of the previous 60-to-90 day window, under the Tax Cuts and Jobs Act), it’s treated as a regular distribution. In that case, the income tax and early withdrawal penalty would apply.

Special COVID-19 401(k) Loans for 2020

Similar to the special provisions for hardship withdrawals that qualify as a CRD, loans taken from a 401(k) between March 27, 2020, and December 31, 2020, are also subject to special IRS provisions. Loans of up to $100,000 or 100% of the amount in your employer-sponsored retirement plan (whichever is smaller) taken anytime between Mar. 27, 2020, and December 31, 2020, are eligible for a one-year suspension of payments, though interest will accrue. If you already have an outstanding loan those payments can also be deferred for one year.

Consolidating Debt

You could use a 401(k) loan to consolidate high-interest debt if your credit doesn’t qualify you for a low rate on a personal loan or debt consolidation loan. Comparing how much you’re paying in interest on your credit cards or other debt to the interest rate your 401(k) plan administrator charges can help you decide which is the better deal.

Buying a Home

Your 401(k) could also be a source of cash when you’re planning to buy a home. You could use the money to cover closing costs or hold it in your down-payment savings account for a few months before buying, so the funds are seasoned.

Generally, a 401(k) loan must be repaid within five years, making at least quarterly payments, but the IRS allows provisions for plan administrators to extend the repayment period longer for homebuyers.

Making an Investment

Using a 401(k) loan to invest may sound like a gamble, but it could be appropriate if certain conditions exist. Let’s say, for example, that you want to purchase a home as an investment property. You plan to renovate the home and flip it for a profit but need capital to make the purchase. If you’re confident that the project will yield a big enough return, you could use money from your 401(k) to buy it or pay for renovations, then use the proceeds from the sale to pay back what you borrowed.

When You Have a Comfortable Retirement Cushion

If you’ve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If that’s the case, and your job is stable, taking a loan from your 401(k) may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for example—or, if you have a child in college, as a less expensive alternative to student loans.

Special Considerations

Ideally, your 401(k) plan should have a steady stream of money going in, rather than out. If you do decide to take a loan from your plan—or a financial need makes a hardship withdrawal a necessity—be sure you understand the potential tax consequences of doing so. If you are unsure of the consequences you may want to consider seeking the advice of a qualified financial planner before deciding to take a hardship withdrawal or a loan from your 401(k).

Also, consider how taking that money out may affect the growth of your nest egg over the long term. Taking out a large withdrawal or loan may mean you’ll have to play catch up to reach your retirement savings goal.

Article Sources
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  1. Internal Revenue Service. "Retirement Topics - Hardship Distributions."

  2. Fidelity. "Building Financial Futures," Page 8.

  3. U.S. Congress. "H.R. 748," Sec. 2202.

  4. Internal Revenue Service. "Relief for Taxpayers Affected by COVID-19 Who Take Distributions or Loans From Retirement Plans."

  5. Internal Revenue Service. "Retirement Topics - Plan Loans."

  6. Internal Revenue Service. "Considering a Loan from Your 401(k) Plan?"

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