The Hidden Evils When Employees Opt for a Hardship Withdrawal

I recently received a call from an employee who was considering a hardship withdrawal. If you handle these requests as part of your many HR tasks, you probably see an uptick in these calls during the holiday season.

Tammy, a single mom, was seeking a solution to paying off her credit card debt and felt that tapping her retirement fund could be an easy fix. Now, we all know that paying off debt is not an acceptable hardship based on the IRS’s definition of an immediate and heavy financial need, but many employees will simply say the money is needed for avoiding eviction or another acceptable hardship when in fact their intent is to use it to pay off credit card debt.

When Tammy called, she was already aware of the typical tax consequences of the hardship withdrawal, which included Federal tax, state tax, and the 10 percent early withdrawal penalty, but she was willing to pay that price.

She was also aware that she would be frozen out of the plan for six months and would not be able to make salary contributions or receive the company match, but she felt she couldn’t afford to keep contributing anyway. What she wasn’t considering were the hidden tax consequences that the additional taxable income from the distribution would cause.

After discussing all the hidden evils that would significantly reduce her tax refund she was counting on, we talked about some alternatives to tackling her credit card debt, none of which would give her the quick fix that a hardship withdrawal would. However, by facing her credit card debt head on with a debt repayment plan and some good budgeting strategies, Tammy would benefit in the long run by establishing new financial habits and could be debt-free in as little as three  years.

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  • Tammy had a student loan, but she would lose the tax deduction of the student loan interest if the hardship withdrawal increased her AGI to over $60,000 as a HOH (head of household) filer.
  • Tammy’s 13 year-old daughter qualified her for the $1,000 child tax credit. However, that credit begins to phase out if her increased AGI pushed above $75,000 for the year.
  • Not only would Tammy not get the company match for six months, she also would become ineligible for the Saver’s Credit, which provides up to a $1,000 Federal tax credit for contributing to a retirement plan. Any distribution counts against the credit.
  • Probably the biggest tax credit impacted for Tammy would be the Earned Income Tax Credit. The EITC could be worth over $3,000 for a mother with one child that qualifies.

Some of our clients have begun to require their employees to seek financial counseling prior to being approved for a hardship withdrawal. Consider that option as a way to expose these hidden evils to your employees.

This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.

Linda Robertson is an experienced financial planner with, the nation’s leading provider of unbiased financial education programs to corporations, credit unions and municipalities with over 400 clients across the country. Her focus is on retirement and tax planning, and her background includes positions with NationsBank, H & R Block, and Metropolitan Life. Contact her at .