The past four years have seen layoffs, raise freezes, eliminated bonuses, foreclosures, upside-down mortgages, increased college tuitions, soaring gas prices, expensive groceries, wildly high credit card rates, and more. It’s no wonder American household budgets have suffered.
When incomes aren’t keeping up with living costs, and expenses are mounting, some savers may start to consider desperate measures, including taking money out of their retirement plans before reaching retirement age. Accessing 401(k) funds prior to retirement is tricky and sometimes confusing. Money can be removed in the form of a retirement plan loan or a hardship distribution. When considering any of these options, it’s important to recognize all of the consequences, including which options are accompanied by stiff IRS penalties.
Hardship distributions from 401(k)s are subject to a 10 percent IRS penalty and regular income tax. The IRS gave you special tax benefits for contributing to your retirement plan, and they want to incentivize you to use the money for retirement, not before. To be allowed to take a hardship distribution, you must show you have an “immediate and heavy financial need” and you’ll most likely have to prove you meet certain criteria. You can only withdraw enough to meet your need. In many cases, your employer may be required to stop your contributions to the plan for a specific amount of time as well.
Individual Retirement Accounts (IRAs) cannot offer loans, but the IRS is less stringent about 401(k) retirement plan loans. The maximum amount a participant may borrow from his plan is 50 percent of the vested account balance or $50,000, whichever is less. An exception to this limit is if 50 percent of the vested account balance is less than $10,000; then, the participant may borrow up to $10,000. Take note: Plans are not required to offer this exception, so check with your plan document for specifics. It’s also important to keep in mind that while you likely made pre-tax contributions to your 401(k), you’ll be making after-tax payments to repay your loan, which significantly increases the cost of the loan.
Such 401(k) hardship distributions and retirement plan loans shouldn’t be a first consideration when you need money. Most financial professionals would tell you that damaging your retirement savings efforts in order to procure a one-time cash injection isn’t worth it.
The truth is that it’s almost always a poor choice; but every financial situation is unique. If 401(k) account dollars will just provide a temporary stopgap before you ultimately run out of money, leave your 401(k) alone. However, if you need the cash to put yourself on much better financial ground and a one-time withdrawal or loan will solve your financial fix, it may be reasonable to consider the possibilities.
Before taking either a 401(k) hardship distribution or a retirement plan loan, I’d suggest considering the alternatives below:
Before you make a life-changing decision about your 401(k) account, it may be helpful to talk with a financial adviser who can offer a new perspective and look at your financial difficulties with fresh eyes. You’ll definitely want to get the specifics about your plan, so reach out to your HR coordinator for more information.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.