How to Calculate Taxes Owed on Hardship Withdrawals

Three Parts:Checking Eligibility for Hardship WithdrawalsCalculating Tax LiabilityConsidering Other Options

Hardship withdrawals from your 401K incur penalties and taxes that cause the money that goes into your pocket to be much less than the amount you originally deducted. While it's discouraging to see your hard-earned cash flee so quickly, it's sometimes relief enough to have some cash in hand when it is seriously needed. However, when taking a hardship withdrawal, you need to be cautious to calculate the taxes you will owe on it. If you don't, you could be hit with a big, unexpected tax bill come tax season.

Part 1
Checking Eligibility for Hardship Withdrawals

  1. 1
    Learn the consequences of hardship withdrawals. Withdrawals can be taken from your retirement account before your retirement age in the form of hardship withdrawals. These withdrawals are designed to give retirement account holders the option to take out part of their retirement to cover emergency expenses, such as bills during a period of unemployment or high medical bills. However, the law is designed to discourage this type of withdrawal by applying steep tax penalties in most cases.
    • Unless your withdrawal specifically qualifies as penalty-free, you will pay a tax penalty.
    • In addition, you will be charged income taxes on your withdrawal in most cases.
    • Finally, the real cost of your early withdrawal is in money you won't have during retirement. This because even more damaging the younger you are, as a withdrawal left in your account would have continued to earn interest until retirement.[1]
    • If you take out a hardship withdrawal, your 401(k) will also be "frozen" for six months. This means that you will be unable to deposit funds during this time (or receive employer matching).
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    Determine if your needs qualify for a hardship withdrawal. Various circumstances qualify as hardships. If you or your spouse have considerable medical expenses that you cannot pay, you may be able to acquire funds from your 401K to pay your bills. Money from a withdrawal may be used for a real estate purchase that becomes your primary residence, or to stop eviction or foreclosure proceedings of your permanent home. Other hardship examples include college or education-related costs, repairs to your home, and funeral expenses.
    • Retirement plans like 401(k)s and 403(b)s may, but are not required to, offer hardship withdrawals. These withdrawals may be limited to different circumstances, depending on your plan.
    • Read the language of your account agreement to determine whether or not hardship withdrawals are allowed.[2]
  3. Image titled Calculate Taxes Owed on Hardship Withdrawals Step 2
    Check if your withdrawal will incur a penalty. Anyone who withdraws from his or her 401K before they turn 59.5 years old is penalized with a fee of 10 percent of the withdrawal. This fee is assessed on top of income taxes. So, for example, if you were in the 25 percent income tax bracket and took out a non-exempt withdrawal before age 59.5, you would pay a total of 35 percent (25 income plus 10 penalty) in taxes on the withdrawal.[3]
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    Check if you qualify for penalty-free withdrawal options. The IRS offers exceptions to the tax penalty under certain circumstances. For example, there is no fee assessed if the participant (the account holder) is dead, permanently disabled, or over the age of 59.5. There is also no penalty if the participant is a military reservist called to active duty or if they have medical bills totaling more than 7.5 percent of their adjusted gross income (the income on your tax return).
    • You can also make penalty-free IRA withdrawals for qualifying educational expenses, to cover health insurance premiums while unemployed, and home improvement expenses up to $10,000.[4]
    • Court-ordered withdrawals, such as for payment to a spouse in divorce, may also be penalty-free.[5]
  5. 5
    Gather documentation of your hardship. If a 401(k) allows for hardship withdrawals, it will also specify what information, if any, must be supplied to the employer to prove hardship. In general, the participant's finances will not be analyzed by the employer. Rather, the employer can typically rely on the participant's explanation of their situation, unless they have information to the contrary. Talk to your employer or 401(k) administrator to check documentation requirements for your plan.[6]

Part 2
Calculating Tax Liability

  1. 1
    Finalize the amount of your withdrawal. Depending on your plan, you may be limited on how much you can withdraw. While IRAs will allow you to take out as much as you want, employer-supported plans like 401(k)s will likely limit your withdrawal to money that you have contributed to the account. This means that matched funds supplied by the employer, earned interest, and previous withdrawals will typically not be available to be withdrawn. However, individuals plans may allow for some or all of these amounts to be withdrawn, depending on your circumstances.[7]
    • Fully vested employer contributions may also be available for withdrawal under some plans.[8]
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    Determine your current income tax bracket. You may be able to determine this by consulting your tax return from the previous year or by checking with the IRS. The IRS website has tax schedules that should give you this information. You need to know your gross income, filing status, and deduction amounts in order to use the tax schedule tables.
    • Be sure to use the most recent tax bracket information when determining your tax rate.[9]
    • Be careful when figuring the taxes for your hardship withdrawal. If you're on the edge of a tax bracket, the hardship withdrawal income may push you into the next bracket, which will leave you owing more taxes than you originally budgeted.
  3. 3
    Treat the withdrawal as income. The withdrawal will usually be treated as income and taxed accordingly. Calculate your tax liability by multiplying your marginal tax rate by the amount of the withdrawal. For example, if you are in the 25 percent tax bracket, the federal tax on a $25,000 withdrawal is $6,250.[10]
    • Roth IRA withdrawals are not typically taxed, provided the account is more than five years old and the money is used for a home purchase or improvement, because the participant suffers a disability, or because the participant has died.[11]
  4. 4
    Add in the early withdrawal penalty, if applicable. Calculate and add in your early withdrawal penalty if your hardship withdrawal is not exempt from it. This amount is added together with your income tax to determine your total taxes on the withdrawal.[12] For example, if you incurred a 10 percent penalty for your $25,000 hardship withdrawal, you will owe $2,500 in penalties. With just federal tax and penalties, you lose $8,750 from your original withdrawal of $25,000.
    • This leaves you with $16,250 to use for expenses or other hardship purposes

Part 3
Considering Other Options

  1. 1
    Keep an emergency fund. Even though at this point you will have likely exhausted any emergency fund you had, it's important to remember that it is critical to keep one. Try saving about three to six months worth of income over time. This emergency fund will typically be enough to carry you through a period of unemployment or a medical emergency. If you don't have an emergency fund now, actively save for one so that you won't have to make withdrawals from your retirement fund.[13]
  2. 2
    Take out a loan against your retirement account. Depending on your retirement account's terms, you may be able to take out a loan against the money held in the account. This loan is taken out from the account provider, but does not represent a withdrawal from your account. However, if you fail to repay the loan, it becomes a withdrawal and will be subject to a 10 percent penalty. These loans are not subject to taxes or penalties if properly used and repaid.
    • These loans must be repaid in under five years using regular loan payments.[14]
    • Contact your 401(k) administrator for more information and to check your eligibility for this type of loan.[15]
    • In most cases, you can borrow up to half of your account balance, up to a total loan of $50,000.[16]
  3. 3
    Use a personal loan or line of credit. If you can't get a loan from your retirement fund, you can try applying for a personal loan or line of credit from your bank or credit union. Lines of credit are typically extended in amounts up to $5,000 or $10,000, depending on your ability to qualify for them. This option is best if you are unsure how much you will need, as you can borrow needed sums over time rather than a set amount all at once.[17]
  4. 4
    Declare bankruptcy. In extreme cases, your debts may be so insurmountable that your only option is to file for bankruptcy. Keep in mind that filing for bankruptcy should be your absolute last resort, to only be used after you have explored every other option. If you do file for bankruptcy, however, your retirement accounts will be exempt from creditor action. Almost all retirement account types and values are completely exempt from being taken in bankruptcy court. So, if you do decide to go this route, at the very least your retirement will be intact.
    • The one exception to this rule is that Roth IRA account balances over $1,283,025 are not exempt.[18]

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Categories: Managing Your Money | Taxes and Fees