What You Need to Know Before Raiding Your Retirement Plan

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.