More Workers Take 401(k) Early Withdrawals

These early distributions can come with significant financial penalties.

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Workers are increasingly tapping their retirement accounts early to prevent foreclosure or eviction, pay for college, and purchase a home. The percentage of 401(k) participants taking loans and hardship withdrawals has jumped significantly over the past year.

Some 11 percent of 401(k) account owners initiated a loan over the past 12 months, up from 9 percent a year ago, according to an analysis of nearly 17,000 Fidelity retirement accounts with 11 million participants released today. And 22 percent of 401(k) participants currently have a loan outstanding. The average initial loan amount is $8,650, which is to be repaid with interest over three and half years.

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“The current economy has forced some workers to borrow from their 401(k) accounts in order to pay for critical living expenses, ultimately jeopardizing their future retirement,” says James MacDonald, president of workplace investing at Fidelity Investments. “For some, taking a loan or a hardship withdrawal from their 401(k) may be their only option because it’s their only form of savings.”

401(k) participants are generally allowed to take a loan of up to 50 percent of the vested account balance or $50,000, whichever is less. If the loan is not paid back with interest it is considered a 401(k) withdrawal and may become subject to taxes and penalties. If you are laid off or leave your job before paying back the loan, the balance becomes due. Some employers also require the loan recipient to pay origination and maintenance fees for the loan.

[See 7 Ways the Automatic IRA Would Impact Retirement Savers.]

Hardship withdrawals, while less common than 401(k) loans, are also increasing. During the second quarter of this year, 62,000 participants initiated a hardship withdrawal, up from 45,000 early withdrawals in the first quarter, Fidelity found. Almost half (45 percent) of retirement savers who took a hardship withdrawal a year ago also took another one this year.

To qualify for a hardship withdrawal employees must demonstrate an immediate and heavy financial need for the money, according to the IRS. Expenses that may qualify include medical costs, the purchase of a primary residence, the prevention of eviction or foreclosure, the repair of home damage, college costs, and burial or funeral expenses. Other sources of savings usually must be exhausted before you qualify.

[See Tapping Retirement Accounts to Cope with Unemployment.]

Early 401(k) withdrawals can be costly. Those who withdraw money from their workplace retirement account before age 59 ½ (or age 55 if they leave their job) must pay a 10 percent early withdrawal penalty and regular income tax on the amount withdrawn. Most workers who take a hardship withdrawal are between 35 and 55 years old and, therefore, must pay the resulting penalties, Fidelity found. Employees are also generally prohibited from making new contributions to the 401(k) plan for at least 6 months after the distribution.

It doesn’t help that many 401(k) accounts have lost value in recent months. The average Fidelity 401(k) account balance was $61,800 at the end of June 2010, down from $66,900 at the end of March 2010.