IRA Hardship Withdrawal: How Taking a Distribution for Financial Need Impacts Taxes

IRA Hardship Withdrawal: How Taking a Distribution for Financial Need Impacts Taxes

A hardship withdrawal is an unplanned distribution of retirement funds because of an immediate financial need. Usually, IRA retirement plans such as 401(k) and 403(b) allow for early withdrawal, provided you meet certain eligibility criteria.

However, before deciding to take a hardship withdrawal, it is important to consider how an early withdrawal will impact your taxes. We will discuss what hardships qualify for IRA hardship withdrawal and how these early distributions are taxed.

What Is IRA Hardship Withdrawal?

An IRA hardship withdrawal refers to an early withdrawal from an Individual Retirement Account due to an immediate financial hardship. Generally, any withdrawal made from a traditional IRA before age 59.5 is considered “early” for IRS taxes.

What Hardships Qualify for a Financial Need Withdrawal?

The IRS clearly stipulates what situations are hardships. Basically, a hardship must pose an “immediate and heavy financial need” to qualify for an early financial need withdrawal.

Qualified hardships include:

  • Some medical expenses.
  • Expenses related to buying a principal residence.
  • Education-related expenses, including tuition.
  • Funeral or burial expenses.
  • Payments that prevent foreclosure or eviction from a principal residence.
  • Some expenses related to repairing a principal residence.
  • Some natural disasters.

How Does an Employer Determine “Immediate and Heavy Financial Need”?

An employer reviews IRA plan terms as well as an employee’s hardship circumstances to determine whether they have an immediate and heavy financial need. This need must be tied to qualified hardships as defined by the IRS. The same ones outlined above.

Also, an employer may consider whether this financial need was reasonably foreseeable or completely unexpected.

Do You Pay a Penalty for IRA Hardship Withdrawals?

If you withdraw funds early from an IRA account, you may have to pay a 10% early withdrawal penalty in addition to incomes tax on the distribution amount.

However, there are penalty exceptions, such as using the funds for higher education expenses, buying a first home, paying for medical expenses that exceed a certain percentage of your income, or in cases of disability or death.

Is an IRA Hardship Distribution Considered Early Withdrawal?

As we have been discussing, an early hardship distribution can be made from an IRA only if it is due to the following conditions:

  • There is an immediate and heavy financial need as determined by an employer and IRS hardship requirements.
  • The participant has a limited amount of funds needed to satisfy financial need.

How Much Can You Take for an IRA Hardship Withdrawal?

How severe your financial hardship is determines how much of an early IRA withdrawal you can take. Generally, you are bound to stay within the financial hardship limits outlined in your retirement plan.

Additionally, your plan could restrict your IRA hardship withdrawal based on your existing contributions. Before you make any early withdrawal, check how much you can access from your IRA to comply with hardship rules.

How Are IRA Hardship Withdrawals Taxed?

Hardship withdrawals are treated as taxable income. IRA hardship withdrawals from a traditional IRA are taxed at ordinary income rates in the year of withdrawal. Hardship taxes are separate from your 10% early withdrawal penalty.

If You Can’t Afford Your IRA Hardship Withdrawal Taxes, Will You Qualify for Currently Not Collectible or Other Tax Relief?

Yes. You may qualify for Currently Not Collectible or other IRS tax relief if you continue to experience financial hardship and therefore cannot pay IRA hardship withdrawal taxes.

To qualify for CNC status, you must demonstrate to the IRS that your dire financial situation persists and that you cannot pay for basic living expenses and taxes.

Are There Alternatives to IRA Hardship Withdrawals?

Generally, hardship withdrawals from an IRA should be a last resort, as they have significant long-term consequences for retirement savings.

If you are looking for alternatives to IRA hardship withdrawals, here are a few options to consider:

  • Emergency fund
  • Temporary loan
  • 401(k) loan
  • Government assistance programs

An IRA hardship withdrawal can provide you with access to immediate funds in times of urgent financial need, like when faced with medical emergencies or eviction threats.

However, before making any decisions regarding your early hardship withdrawal, it is advisable to consult with a financial advisor or tax professional. This way, you can fully understand the short-term and long-term implications of taking retirement money early.

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