What it is:
A hardship withdrawal is a premature withdrawal of money from a retirement account on account of special circumstances.
How it works (Example):
Retirement plans -- for example, 401(k)s and IRAs -- have special tax treatments that encourage individuals to save. The cash value of these plans cannot be accessed like demand deposits (checking account, savings account) and usually cannot be tapped into until holders have reached the age of 59 1/2.
Under certain extraordinary circumstances, a holder may need to withdraw some or all of the money from his or her retirement plan. By making this hardship withdrawal, a holder automatically incurs a penalty that reduces the amount withdrawn, usually by 10%. For example, a hardship withdrawal of $5,000 actually provides a holder with $5,000 x 0.9 = $4,500.
Why it Matters:
The penalties on hardship withdrawals serve as a disincentive for plan holders to make premature withdrawals. Additionally, plan holders must report the withdrawal amount as part of their annual income for tax purposes. For these reasons, individuals are advised to resort to hardship withdrawals as a last option in times of financial strain.