If you're suffering a severe hardship, taking an early withdrawal from a tax-advantaged retirement account may be your only choice. Although hardship withdrawals are permitted from many types of retirement accounts, before you proceed you should be aware that the penalties for doing so are stiff, unless you meet specific Internal Revenue Service (IRS) rules.
IRA Hardship Distributions
According to the IRS, an IRA owner may take an early distribution at any time; however, the penalties and tax treatment may be severe. In general, if you are younger than age 59 1/2, you'll incur a 10 percent penalty, in addition to having the distribution added to your gross income. This means that your distribution will be taxed at your current income tax rate, which may be as high as 35 percent as of the time of publication. In addition, your account custodian may impose a penalty of its own.
The federal government recognizes that many may need to access their funds for legitimate reasons, and as such there are some exceptions to the early IRA distribution rule. If your hardship is a result of needing to finance higher education expenses or a first-time home purchase, then you may withdraw the funds you need without penalty. Keep in mind that you'll still be taxed at your current rate. In addition, if your hardship results from hurricane damage, then you're not only allowed to take up to $100,000 in distributions, but you may take advantage of favorable tax treatments, as well.
The Loan Loophole
If your hardship is temporary and you can replace the borrowed funds within 60 days, you can take a distribution tax-free. The federal government allows IRA owners to request a check from your account for the purposes of setting up a new account and gives owners 60 days to accomplish the transfer. Keep in mind that most hardships can't be eliminated within 60 days; however, this may be an option if you're expecting a big influx of cash -- and soon. If you cannot replace the distribution within 60 days, you'll be subject to the 10 percent penalty as well as income taxes.
An Alternative Option
Another alternative is borrowing from your 401k instead. While early 401k distribution rules are even more strict than the IRA rules, most 401k plans allow owners to borrow. Keep in mind that you don't need to prove a hardship. Simply tell your plan administrator why you need the money, and begin making repayments, with interest, to yourself. You won't have to submit to a credit check, and the loan isn't taxable as income. Plan rules vary, however, so be sure to check with your employer or administrator to find out how to proceed.
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