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 when calculating the taxes you will owe on the money you receive. If you don't, you could wake up to a rude awakening and a big tax bill when your taxes are due.
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.
Check if your age prevents you from withdrawing without a penalty. Anyone who withdraws from his or her 401K before they turn 59 1/2 years old is penalized with a fee of 10 percent of the withdrawal.
Ask questions about penalty-free withdrawal options. Some employers provide options for their employees to withdraw funds under special hardship considerations. Not all employers provide this option. Here are some examples of options offered by many employers: total disability; fired or laid off permanently the year you turn 55 years old or older; court ordered to disburse money to divorced spouse, dependent or child, or indebtedness for 7.5 percent of adjusted gross income due to medical bills.
Calculate your taxes based on your current 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. Typically, hardship withdrawals are taxed between 25 to 35 percent. Here is an example of the tax rate for a withdrawal of $25,000. If you are in the 25 percent tax bracket, the federal tax on that withdrawal is $6,250. If you incurred a penalty for your hardship withdrawal, you will owe $2,500 in penalties. With just federal tax and penalties, you lose $8,750 from your original deduction of $25,000. This leaves you with $16,250 to use for expenses or other hardship purposes.
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.