What You Need to Know Before Raiding Your Retirement Plan

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The way things are going, the recession that’s now officially over is still hurting people and may do so for decades to come. And that’s not just an opinion. A survey last week by SunLife Financial contained this depressing fact…

Less than half of respondents (42 percent) are very confident that they will now be able to take care of basic living expenses in retirement, and only one in four have strong confidence that they will be able to take care of medical expenses. Just under 20 percent believe they will never fully rebuild from their financial losses.

One thing that might be contributing to the average worker’s lack of gold for their golden years? The record number who have raided their 401(k) retirement accounts. As I mentioned in the video above, investment manager Fidelity says 2.2 percent of workers have made a hardship withdrawal from a 401(k) in just the last year – the highest in a decade. Also a record: the number 401(k) loans, now at 22 percent.

There are two ways of tapping your retirement savings: a hardship withdrawal or a loan. Let’s look at both.

Hardship withdrawals

There are two kinds of hardship withdrawals: the kind that come with a penalty and the kind that don’t. In order to qualify for a penalty-free hardship withdrawal, you have to meet one of the following conditions:

  • You become totally disabled.
  • You are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
  • You are required by court order to give the money to your divorced spouse, a child, or a dependent.
  • You lose your job through permanent layoff, termination, quitting or taking early retirement in the year you turn 55, or later.
  • You lose your job and have set-up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy.

There are also situations where you can tap your 401(k) and pay a 10 percent penalty to get to your money (if you’re under the age of 59 1/2). They include:

  • Un-reimbursed medical expenses for you, your spouse, or dependents.
  • Purchase of a principal residence.
  • Payment of college tuition and related educational costs such as room and board for the next 12 months for you, your spouse, dependents, or children who are no longer dependents.
  • Payments necessary to prevent eviction of you from your home, or foreclosure on the mortgage of your principal residence.
  • Funeral expenses.
  • Certain expenses for the repair of damage to the your home.

In addition to potential penalties, another issue that makes hardship withdrawals a bad idea is income taxes. Whether you’re subject to a penalty or not, any money you take out of your 401(k) will be taxed by Uncle Sam as if it were gross income. Here’s an example, assuming you’re in the 25 percent tax bracket (2010 taxable income between $34,000 and $82,000):

Hardship withdrawal Amount: $10,000
Penalty (if applicable): 10 percent, or $1,000
Increased income tax: $2,500
Net cash: $6,500

Paying what amounts to a 35 percent fee to get to your own money makes it clear that 401(k) withdrawals are a bad idea. And one final caveat: even if you qualify for a hardship withdrawal in either of these categories, your employer is not required by law to offer it. So before you think of using this last-ditch method of getting money, talk to your employer to see if it’s even an option.

Learn more about hardship withdrawals at this page of the IRS website.

Loans from your 401(k)

It’s not hard to understand why a cash-strapped employee would borrow from their 401(k). The three biggest advantages to 401(k) loans when compared to other types of loans…

  1. You don’t have to qualify. If you have a 401(k), you can borrow up to half your balance, no questions asked, up to $50,000. But it must be repaid within 5 years, although if you’re buying a house, that can sometimes be stretched to 10 or 15 years.
  2. Your interest rate will probably be lower than with other loans. Typical rates are prime + 1 percent: As I write this, the prime rate is 3.25 percent, so you’d be paying 4.25 percent.
  3. You’re paying that interest to yourself, rather than a bank or other lender.

Most employers will even deduct your loan payment directly from your paycheck, so you don’t even have to worry about missing a payment.

Not as good as it sounds

There are several serious side effects to 401(k) loans that may not hurt you now, but could cause you pain later. The most obvious: By borrowing your own retirement money, you’re trading the future for the present. True, you’re paying it back with interest – but you’re also taking that money out of one pocket to put it in the other.

Other drawbacks…

  1. If you lose your job, whether by quitting or being laid off, you’ll have 60 days to repay the entire loan. (The average loan is $8,650 – a big chunk of change.) If you don’t repay the loan within that time, it will be counted as a distribution: 10% penalty, extra income taxes.
  2. Interest on the loan isn’t tax deductible, even if you’re borrowing to buy a house.
  3. Like hardship withdrawals, while 401(k) loans are allowed by the law, your employer isn’t required to offer them. And they may come with restrictions: Your employer may only allow loans to meet expenses like college costs, buying a first house, or preventing eviction from your home.

Other Options

Depending on your situation, there may be options other than 401(k) loans or hardship withdrawals…

  1. Raid a Roth: If you have a Roth IRA or 401(k), your contributions were made with after-tax money, so you can withdraw your original investment – not the earnings – without paying penalties or taxes. Obviously, however, taking money from any retirement plan will handicap your retirement goals.
  2. Bankruptcy: If you’re unable to pay your credit card or other debt, you’ll be tempted to tap your retirement accounts to get the collection agencies off your back. Don’t if you’re ultimately forced into bankruptcy, your creditors can’t touch your 401(k) or IRA. So if you’re at the end of your rope and that’s all the money you have left, leave it there and talk to a lawyer.
  3. Medicaid: If you’re unemployed and facing uninsured medical bills, you may qualify for certain types of medicaid. Taking withdrawals from a retirement account may complicate that process – again, talk to a lawyer.
  4. Get fatter paychecks: If you just need a little extra to make ends meet, temporarily stop contributing to your 401(k).

Bottom line? If you’re contemplating tapping your 401(k), a loan definitely beats a withdrawal. But if you’re considering either because of debt problems, seek out credit counseling first. Check out Help With Debt: Credit Counseling.

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  • http://pulse.yahoo.com/_RHJLYV6KJAKTCNVQFOE6O4CX2E Tom

    I am a 60 year old architect. The market for architecture isn’t that great and I’m concerned about the potential of either eroding my retirement funds and/or possibly losing a house purchased in ’98 with the hopes of living in my future retirement account. I have some $180,000 in my own IRA and have inherited an IRA from my parents worth about the same amount. I am very concerned with the future rise in tax rates, inflation and the reduced purchasing power of the dollar. I have 6 month of living expenses squirreled away and am mainly concerned about possibly losing my house with any long term economic problems. With that in mind, I’m thinking it makes the most sense to withdraw the funds of at least one of those accounts, bite the bullet to pay the taxes due at the current maximum rate, and use the remaining money and some savings to purchase a much smaller house for cash. My current mortgage is $1,050K for a house that was originally appraised for $2,100K and reappraised when I refinanced about 6 months ago at $1,600K. While I have a lot of equity in the house, it’s been on the market for 2 years with about 4 lookers and no offers. I have an interest only loan at a rate of less than 5% that is guaranteed for 10 years and can never go more than 2% higher for the life of the loan. Even with those terms, with a debt free place to live, I could then afford to sell my existing house for basically what’s left on the mortgage and be 100% debt free, maintain a stellar credit rating, and then concentrate on simply saving money instead or worrying about paying the mortgage, insurance, flood insurance, home owner dues, utilities, and on and on. I understand well the concept of the compound growth and the theoretical reduced taxes in the future when I’m not making the salary I typically enjoy, however this year will be a slow year and it may well be that way for many years to come. Why not take advantage of that, pay my taxes and not worry about ever losing my house? A luxury that I certainly don’t enjoy now. I’m not in great health. I do have a long term care insurance policy that I’m concerned may be worthless if my insurance company goes under. I have some physical gold and silver. Current IRA’s are about 20% in precious metals and TBT, with the remainder in a Money Market account. I just want to be sure to have a place for my family that no one else can touch. Am I wrong with this thinking?

    Tom

    • http://pulse.yahoo.com/_RB5WQHG7AOZD7TPJVOJ53MD3QQ patriot

      If you’re 60, what family do you have? If u take 401 $$ you’re over 57&1/2, so no penalty, but you’ll have to pay taxes on the money which may put u in a higher tax bracket. Why flood insurance? Is it required for the mortgage? Don’t spend any more cash than you have to! Keep it in a safe place, like canadian dollars. If the economy tanks, the bank will eat the house, not you. Make sure all the money is safe from banks or investments going bankrupt. If the economy improves, your house will sell & u can get out of there. Buy something with minimum cash (are u a vet?) & not in a flood plain or tornado alley. You may want to teach a course at the local univ or JC, as you are a college graduate with an architect’s license, if times are slow-they’ll cover your meds if u do. Family=wife, dog/cat, maybe older parents who should have medicare & ss or even ssi, which they can take wherever u go, once u go. If u paid into ss, you’ll need 6+ years to collect. Don’t wait that long-collect it asap, as it may go broke in your lifetime. If u invest in stocks, buy the best/oldest with highest dividends. Try to keep as much cash as possible in a safe place (not a bank). If u open a canadian bank account, make sure u send less than $10,000-more will attract the IRS. Stay away from cities, they can riot & charge high property taxes. Food chains can easily be interrupted. Screw the stellar credit rating & the debt free-you can’t be Mr Nice Guy & survive. The folks who caused all this weren’t!! With some of that saved living expenses, go buy canned goods or dry rations for survival. 5 gal jugs of water have a shelf life of 2 years. When Katrina hit, folks tore the water from the nice guys hands-get enough for a few months for your family. Face it, the dollar ain’t worth much any more. If the house sells, u may want to move to another country-hope the family has passports-if not, do this asap! Also, hope u have a few guns (for protection of course). As an architect, u may live in a nice house or have nice cars, which attracts lesser folks (who want what you’ve got). Start looking poorer-house more run down (if homeowners will let you), lesser cars, etc., night lites all around, dbl door locks, alarm system, a big dog or 2! If things get really bad, have an escape plan to someplace safe u can get to. If BO gets in, some folks will leave the country, so be prepared-the USA won’t be the same. If u have home owners, u must be in a gated place. Think about if u lost the house, but saved your family-worth it? If Ghadafi & Hussain had left the country,they’d be alive now! Worth it? If your gold & silver are in a bank & their doors close like in the 30’s, you’re SOL! Plus u can’t eat it. Remember, Noah built the arc when it wasn’t raining! Slow years before ss kicks in will determine how much you get! If that insurance co. bothers u (Bankrupt), get another policy with another co. You’re not wrong with this thinking because u (like me) have a lot to lose (X Boeing Helicopter manager). Why take chances, we got degrees for a job to support our families-now we’re gonna lose it all to bums? I’m 77 w/bad back, but have waterfront in Canada where they speak english, money is equal & so is medical & banks are solvent. Think the best, but prepare for the worst. At least you’ll be ready if something bad happens! But don’t be naive!!!!!!!Stick less than $10k in every bank in Canada. You need a tax lawyer to pull that money out without a tax penalty-don’t do this yourself. When Castro got in Cuba, my relatives could only leave with what they could carry after a lifetime of living there & contributing to their economy. All their homes, waterfront land & sugar mills, stocks & bank accounts were gone & their employees were shot & killed. I was there.  Be prepared.
      Good luck
      A patriot

  • JST Books

    How is the interest paid on the loan? can you tell me about this.

    pension loan