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BORROWING FROM MY 401(k) helped my wife and me buy our home in 1997. I’m grateful I was able to reach inside my retirement plan for the money we needed for the house down payment.
Experts often warn against 401(k) loans because, even if the loan is repaid, the money borrowed can miss out on investment gains. That’s certainly a risk. Still, there’s a second way of taking money out of a 401(k)—and it’s far more harmful to retirement savings. It’s called a hardship withdrawal, and it’s grown more popular in recent years.
A hardship withdrawal differs from a 401(k) loan in that the money isn’t repaid. Instead, the worker owes income taxes on the money taken from the account, plus a 10% early withdrawal penalty in most cases. The tax cost would be 32% for a single person earning $60,000—not to mention the big hole made in his or her retirement savings.
Even 401(k) loans should be used sparingly. Forget the opportunity cost of missed investment gains. The big risk is that you lose your job with a loan outstanding. If that happens, the loan typically has to be repaid in full in 30 to 60 days, depending on plan rules. If the money isn’t promptly repaid, the outstanding balance is subtracted from savings, and subject to income taxes and usually an early withdrawal penalty.
This is the worst-case scenario with a 401(k) loan—but it is, alas, business-as-usual for a hardship withdrawal. Yet, despite the hefty cost, hardship withdrawals have only become more popular and easier to get in recent years. People who badly need money should take it from their plan savings using a loan. But instead, they compound their problems by taking a hardship withdrawal.
Why would someone opt for a hardship withdrawal rather than a loan? Sometimes, a hardship withdrawal is the only option. According to data from Vanguard Group, a big administrator of 401(k) plans, 94% of plans offer hardship withdrawals, but only 81% offer plan loans. Another reason for hardship withdrawals: A worker may already have a loan outstanding, and many plans only allow one or two loans.
A third reason could be naivete—and semantics. For workers in a financial jam, a hardship withdrawal may sound like the right answer to their exact circumstance. Hardship withdrawals are permitted for only six reasons:
Many of these situations are stressful and pressured, and not the time folks are inclined to carefully weigh their options. Employers used to slow down the process by requiring proof of need—an eviction notice or medical bill—before issuing hardship money. The financial need had to be immediate and heavy, and the withdrawal was limited to the amount required to meet the emergency.
In 2019, Congress eased the requirements after several destructive hurricanes struck U.S. shores. Workers complained they couldn’t produce the necessary paperwork if their homes had been washed away or if they’d been evacuated from, say, New Orleans to Texas.
Today, by contrast, workers can often simply name their hardship and the amount of money needed using an online application. With less paperwork, payments are faster and more convenient. Predictably, the number of workers taking hardship withdrawals jumped 48% in 2019, to 2.3% of participants in Vanguard-administered plans. If that same percentage applied nationwide, it suggests there were 1.3 million hardship withdrawals in 2019. Roughly 60 million people participate in a 401(k) plan, according to the Investment Company Institute.
In 2020, Congress opened a new door for hardship withdrawals aimed at those affected by COVID-19. People could take out as much as $100,000 penalty-free from their retirement plan account, twice the maximum available through a plan loan. Vanguard said 5.7% of its plan savers took advantage of the one-time program. If that percentage applied to the nationwide 401(k) population, it would work out to more than 3.4 million COVID distributions.
Workers can treat their COVID distribution as a loan, and pay the money back. That way, they’d avoid income taxes and replenish their retirement savings. But they can also treat the money received as a hardship withdrawal and pay taxes in installments—33% each year for three years.
Fewer than 1% of COVID borrowers repaid the money to their plan in 2021, according to Vanguard. The overwhelming majority are treating it as a hardship withdrawal. They’ll pay higher taxes now—and have less money later for retirement. A hardship indeed.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
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As far as the risk of missing out on investment gains with a loan, some plans let the participant set a higher interest rate to charge themselves, so that their 401k plan earns a decent return on the loaned funds. I took out a 401k loan to put a large down payment on my home and put the interest rate at 10%, to assure that “retirement investor me” earned 10% on my loan investment to “borrower me”.
One downside to 401k loans is that the loan payments are double-taxed: First, when the loan is repaid with after-tax dollars, and secondly when the repaid funds are subject to taxation upon withdrawal in retirement. Still, the interest that was paid to my 401k account, instead of a bank, proved advantageous, despite the double-taxation.
To Greg’s point, however, one must be confident that they’ll be at their current job until the loan is paid off, otherwise the benefits of a 401k loan are largely lost.
I’ve served on committees managing 401K and 403C plans during my career and in retirement. One of the things that just bugged me to no end was people getting 401K loans to go on vacation or buy a new pickup truck. Our plan, and I’m not sure about others, did not let you contribute to the plan if you had an outstanding loan so you missed being able to put in more money for retirement and it also kept you from getting the company match. Good post!