One common piece of investing advice suggests only investing money you won't need in the next five to 10 years. The same principle applies when saving money in defined contribution plans, such as a 401(k). Though they have many benefits, withdrawals from these retirement-focused accounts come with a tax bill and 10% penalty if they occur before you reach 59 ½ years of age. In other words, putting money in a 401(k) that you might need before you get close to retirement age is not a good idea.
However, in some cases, the IRS permits penalty-free withdrawals, known as hardship withdrawals. And according to a recent report from Vanguard, a leading investment advisor, these withdrawals are on the rise. Here's a look at Vanguard's data and what hardship withdrawals can mean for your retirement planning.
A trend dating back (at least) five years
Vanguard's annual "How America Saves" report reveals important data concerning the financial habits of almost five million defined contribution plan participants. However, since these figures are based only on the plans Vanguard provides record-keeping services for, they may not apply to the overall population.
Regardless, Vanguard's report contains valuable insights. For example, according to the latest version, based on figures from 2024, 4.8% of participants used hardship withdrawals when their plans offered that option, compared to just 3.6% in 2023.
Furthermore, this year-over-year increase isn't a one-off: The percentage of participants using hardship withdrawals has increased steadily since 2020, rising from 1.7% to last year's 4.8%.
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Should you rely on hardship withdrawals?
Hardship withdrawals exist to help defined contribution plan participants address financial obligations resulting from difficult situations, such as large medical bills and funeral costs, or to cover expenses deemed important by the law, including a down payment on a primary residence, preventing eviction from your current home, college-related expenses, etc. These withdrawals are still subject to taxes, and they're capped at specific amounts.
When disaster strikes and you're looking at your 401(k) for relief, it's essential to consider the potential impact of hardship withdrawals on your retirement strategy. If you have a goal to save a certain amount of money for retirement, a hardship withdrawal could set you back significantly. It's not just about the capital you withdraw from your account. Assuming your savings are invested in productive assets, such as stocks, withdrawing money early for any reason will mean giving up some of your returns.
You could end up with significantly less than you had planned for retirement and be forced to make tough decisions down the road, such as taking on a part-time job or delaying retirement. In other words, a single hardship withdrawal could affect your finances in ways that will trickle down well into your golden years. That's why it's important to make sure you have exhausted all your options before opting for a hardship withdrawal, even if it is for a genuine, approved financial need.
One potential alternative to consider is a 401(k) loan. These have several advantages over hardship withdrawals: Loans for approved uses come with no tax bill and no penalties. That said, they must be repaid within five years, typically with interest, which goes back into your own account. The loan amount is capped at $50,000 or at half of the participant's vested account balance, whichever is lower, unless 50% of the account balance is less than $10,000. In this case, participants can take out as much as $10,000.
Many of the financial emergencies approved for hardship withdrawals also apply to loans. While this option might still result in giving up some of the returns you would have enjoyed if the money had remained invested, the impact on your finances could be far less severe than with hardship withdrawals. You save yourself the tax bill and penalties, and assuming you repay the loan in time, those funds can once again be invested and grow in value over time.
Even if you end up opting for a hardship withdrawal, that need not be a permanent hindrance to your retirement planning. You may not be able to catch up completely once you go that route, but consistently putting money into your 401(k) will still benefit you down the line.
