As a general rule, your 401(k) plan shouldn’t be the first place you look when you need to cover major expenses such as medical bills. But when you have no other option, it might be necessary to tap into your retirement plan by requesting a hardship withdrawal. However, not all medical expenses qualify for a hardship withdrawal.
Medical expenses only qualify for 401(k) hardship withdrawal if they exceed 7.5% of the plan owners’ Adjusted Gross Income (AGI). They must also be excluded from health insurance coverage and be paid for by the plan holder, their spouse, or their dependents.
Read on to learn the following:
- An insightful discussion on the terms and conditions that must be met for medical expenses to qualify for 401k hardship withdrawals.
- Alternative ways to pull money out of your retirement fund if your expenses don’t qualify for such withdrawal.
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Table of Contents
When Can You Apply for a 401(k) Hardship Withdrawal?
You can apply for a 401(k) hardship withdrawal when you meet the following circumstances:
- The size of the medical expense.
- Whether your health insurance covers them.
- The person for whom the medical bills are paid.
You can only pull funds from your 401(k) retirement plan to cover medical expenses for you, your dependents, or your spouse. The expenses must also be unreimbursed (not covered by your health insurance) and exceed 7.5% of your Adjusted Gross Income (AGI).
Failure to meet these requirements disqualifies your medical expenses as a hardship withdrawal. But if you still make a withdrawal despite ineligibility, the 10% penalty applies. And even when your medical expenses meet the above criteria, you must make the hardship withdrawal the same year you, your spouse, or dependant received the medical treatment.
At this point, it makes sense to introduce recent rule changes that will affect the amount you can withdraw from your 401(k) to cover medical expenses.
These changes came with the Bipartisan Budget Act, which took effect in January 2019. It enacted new rules that allow participants to make larger hardship withdrawals from their 401(k) plans to cover qualified medical bills and other eligible expenses.
Here’s a summary of these changes and what they mean for your hardship withdrawal:
- The outgoing regulation framework limited hardship withdrawals to the participant’s salary deferral contributions, which is the money withheld from your paycheck. It also prohibited participants from continuing to make new contributions to their 401k plans for up to half a year after a hardship withdrawal.
- The Bipartisan Budget Act eliminates the above limitations. It allows participants to keep making contributions and also receive matching contributions from their employer in a hardship withdrawal.
It’s also worth mentioning that with the new rules, taking a plan loan is no longer a requirement for hardship distributions.
A Quick Look at 401k Hardship Withdrawals
Knowing the basics of 401k hardship withdrawals is paramount to understanding some of the terms and claims you’ll come across in today’s discussion. To help you with that, let’s cover the basics.
Making a hardship withdrawal means taking money out of your retirement to cover emergencies such as medical bills. While the “emergency” you need to cover needs to meet the IRS’s criteria for “an immediate and heavy financial need,” the plan administrator also has a say on whether you can make such a withdrawal.
Many employers allow hardship withdrawals provided employees can provide substantial evidence of the financial hardship, among other employer-and-plan-specific requirements.
The main selling point of a hardship withdrawal is that you can make it without incurring the standard 10% penalty that typically applies to participants who prematurely pull funds out of their 401k plans before they hit the 59 ½ age mark.
As you’d expect, certain terms and conditions must be met for your medical expenses to qualify for a hardship withdrawal, which brings us to the main subject of today’s discussion.
How Your Employer Can Help You with Your 401(k) Hardship Withdrawal Application?
The 401(k) plan administrator (i.e., your employer) plays a critical role in determining when you can make hardship withdrawals for eligible medical expenses. They set the terms and conditions under which you can make hardship withdrawals for not just medical bills but also other expenses such as:
- Post-secondary education
- Funeral/burial expenses
- Buying principal residence
- Preventing an eviction or foreclosure of your principal residence
- Repair costs for your principal residence arising from a casualty loss that’s eligible for tax deduction per Section 165 of the IRS Code.
The employer’s terms and conditions for 401(k) hardship withdrawals are usually outlined in your plan document. Since these vary with plan and employer, you’ll need to get a copy of this document from human resources to learn your 401(k) specifics.
You can also request your employer to provide you with the Summary Plan Description (SPD) Agreement. The SPD articulates the specific circumstances and when you can pull funds out of your 401(k).
Alternatively, you can request a written explanation for whether your medical expenses qualify for a hardship withdrawal.
What if Your Medical Expenses Don’t Qualify for 401(k) Hardship Withdrawal?
If your medical expenses don’t meet the eligibility criteria for a hardship withdrawal, you can apply for a 401(k) loan. Another option is leveraging the “separation of service” provision. These two methods enable you to use 401(k) out without incurring the 10% penalty.
Let’s take a deeper look at each option below:
Taking a 401(k) Loan
A 401(k) hardship withdrawal is different from a 401(k) loan. There are a handful of distinctions between these two types of 401(k) withdrawals, with the most apparent being that a hardship withdrawal doesn’t allow participants to repay the money back to their account.
The only way to replace funds withdrawn is by making more contributions to the account.
On the other hand, a 401(k) loan requires you to repay the money with interest. Essentially, what you do with this kind of loan is borrow from your own assets.
Should you choose to pursue it as an alternative to a hardship withdrawal, you’ll be allowed to take out up to half of your vested balance or up to $50,000, depending on which of these two figures is lower.
The beauty of a 401(k) loan is that, unlike a hardship withdrawal, you won’t be required to pay income taxes on distribution the year you receive it. It also comes with one of the main benefits of a hardship withdrawal, which is an exemption from the 10% early withdrawal penalty.
However, 401(k) loans come with a few drawbacks.
Among these is that you’re required to repay the loan with interest, typically within five years, to prevent your retirement plan from getting depleted. Also, if you part ways with your employer, you must repay the loan before the end of October the following year.
Despite these drawbacks, a 401(k) loan is worth considering if the need to settle your medical expenses is dire.
Separation of Service Provision
This is another option you can exercise to cover your medical expenses if they don’t qualify for a hardship withdrawal. However, it’s only available if you retire or lose your job when you turn 55 or afterward.
Through the separation of service provision, you can pull funds from your 401(k) plan without incurring the 10% penalty that comes with early withdrawals.
But as with other types of withdrawals, you’ll need to pay income taxes. Of course, this doesn’t apply to participants of Roth 401(k) schemes because contributions for such plans are made post-tax.
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Conclusion
As we’ve seen throughout this post, whether your medical expenses qualify for a hardship withdrawal depends on how big the bill is, your insurance coverage, and the individual for whom the bill is being paid.
For medical expenses to qualify for a hardship withdrawal, they need to be paid for the plan owner, their dependents, or their spouse.
They must also be excluded from health insurance coverage and be more than 7.5% of the plan owner’s Adjusted Gross Income (AGI). Your employer also plays a critical role in determining whether your medical bills are eligible for a hardship distribution.
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