401k Loan or 401k withdrawal?



Loan Alternative

A loan from your 401k is one thing, but withdrawing funds is an entirely different process. A withdrawal from your 401k is called a “hardship withdraw”. Such a withdraw doesn’t need to be paid back like a loan, however it is only granted by the IRS to people under “immediate and heavy” financial need. This means the financial need is imminent and that you must have exhausted all other options. Usually, it is difficult to qualify for a “hardship withdrawal”. Luckily, about 95% of 401k plans allow hardship withdrawals and paying for college tuition qualifies for such a “hardship”.  

The amount of funds that can be withdrawn is limited to only the funds you contributed to the 401k account. In other words, the matching funds deposited by your employer are not eligible for withdrawal. Also, the withdrawal is taxable and subject to a 10% early withdrawal penalty because the funds are being used before you retire. Once the funds have been withdrawn from the 401k they can not be put back or repaid.

Withdrawal Process

To withdraw funds from your 401k you will first need to talk to your employer’s Human Resource office. You will need to apply in writing for a withdrawal and your employer will decide whether you qualify. Your employer will use one of two methods to determine if you qualify for a 401k hardship withdrawal: “proof of need” and “self-certification”.

In the case of “proof of need” you will need to share your financial situation with your employer and demonstrate that your financial situation is dire enough to require a withdrawal from our 401k. This method is unpopular with employers, because they are uninterested in knowing the details of their employees’ lives, and is also unpopular with people making withdrawals, because it requires them to reveal detailed finances to their boss and coworkers.  Perhaps the only advantage to this method is that you are allowed to start contributing back to your 401k with your next paycheck after the hardship withdrawal.

The other method of “self-certification” does not require you to reveal the details of your financial situation, and is therefore much preferred. However, a disadvantage of this method is that this withdrawal process does not let you to make any contributions to your 401k plan for six months after taking the withdrawal; thereby limiting your ability to save for retirement. 

That said, there’s a catch to doing a hardship withdrawal, which is that you can’t get a withdrawal if there are other financial resources available. This includes investments or even a home equity loan. This will usually mean that if you 401k plan allows loans you would have use that option first before being able to apply for a hardship withdrawal.

Obviously, a hardship withdrawal should be a last resort for getting funds to pay for college. A 401k loan is a much more viable option in which you can at least repay the money to yourself with interest.  

There are two options for using your 401k for college:
1.) take out a loan that you pay back to your account, and 2.) withdraw funds which you don’t pay back.

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