Retirement Planning Dreams

401(k) Hardship Withdrawal Q&A

If you’ve learned anything about retirement planning so far, it is probably safe to say you’ve learned not to touch that money you’ve set aside unless you absolutely, positively must. Not quite borrowing, 401(k) hardship withdrawal typically indicates that you’ve met that “must” point in life. Read on to find out what 401(k) hardship withdrawal actually is, what it does to your retirement planning assets, and why you should think long and hard before deciding on a 401(k) hardship withdrawal.

If you absolutely must use some or all of your retirement fund for a personal or family emergency or to pay your bills, 401(k) hardship withdrawal may be the answer… but you might not like what you hear about how it impacts your future in the long run. Find out what the experts have to say about 401(k) hardship withdrawal and whether you should ever consider it as a viable option.

Q. – When is it OK to borrow from your 401(k) / retirement savings (if ever)?

A. – Mackey McNeill, CPA/PFS, member of the AICPA’s National CPA Financial Literacy Commission:
“If you have no other means to pay your bills. With this caveat – retirement assets are protected in bankruptcy and if you are really on the edge and bankruptcy is a possibility, look hard at all your choices before using retirement savings. For all other reasons, down payment on a home, education, etc, do the hard work, prepare a budget, save and make it happen. Don’t short change your future for a fleeting moment of indulgence.”

A. – Richard Barrington, commentator on business and financial developments for MoneyRates.com:
“In just about every situation, this option should be off the table – it’s not a good idea. The only situation in which it seems to make sense is as a short-term bridge loan – if you are in a situation where you have a cash flow timing problem, but you are absolutely certain that the cash flow necessary to repay the loan will be forthcoming shortly.

“An example would be if you are buying one house and selling another – if the house you are buying closes first, you may have to come up with some cash before the house you are selling closes. This would be a classic case where one historically might have gotten a bridge loan from a bank, but those might be tough to come by these days. Even so, you’d better be pretty sure of your old home’s buyer in this case – preferably, with enough of a deposit in escrow to cover the loan repayment if the buyer backs out. Still, I would recommend doing whatever you can to avoid borrowing from a 401(k) – for the reasons described below.”

A. – Larry Heller, Enrolled Actuary, Director of Employee Benefit Services for Becher, Della Torre, Gitto & Co., CPAs:
“Two important things to be aware of at the time you might take a 401(k) loan:  (a) the direction of the stock market and (b) your plans to stay with the company.

“A. Since loans are generally repaid to the participant’s account at a preset interest rate, try to judge whether that interest rate will be higher or lower than investment return the loan balance would have earned had the loan not been taken. In other words, loans can help retirement savings grow if you expect a down market, but will hurt during a strongly rising market.

“B. Very few 401(k) plans permit loan repayments by former employees, which means that the unpaid balance of the loan will become taxable unless it is returned to your 401(k) plan account or included in a rollover to another plan or IRA. If you leave your company with an outstanding loan balance, you have the option to repay it back into your account so that it doesn’t become a taxable distribution. But it’s unlikely that you let the proceeds of the loan sit unused, meaning that you will be stuck with a taxable distribution and, perhaps, an additional 10% tax penalty if prior to age 55, unless you can retrieve the outstanding balance from other personal assets. In other words, be careful taking a loan if you don’t think you’ll be able to repay it before you leave your job.

“And be careful if you expect your paycheck to significantly lessen, perhaps by a cutback to part-time, in which case the loan repayment – usually made by payroll deduction like contributions to the plan – would become a more significant reduction to that paycheck. In the case of temporary layoffs, if more than 90 days go by between loan repayments, the loan is usually considered in default, becoming taxable (and potentially subject to that 10% penalty).”

Q. – How does 401(k) hardship withdrawal work and what are the pros/cons? Is it worth it?
When might someone use it?

A. – Mackey McNeill, CPA/PFS, member of the AICPA’s National CPA Financial Literacy Commission:
“Hardships are not plan loans and are not repaid. There is a 10% penalty for hardship if you are under [age] 59.5. Your employer plan must provide for hardships, so while the IRS gives the rules of what hardships can be considered, the employer plan must allow this. Your first step is to contact your plan administrator. 401(k) money is retirement money. This means it is there for your future, not your present. In days past when employers more frequently offered defined benefit plans instead of 401(k)s, people had no way to access their retirement funds for current expenses. Despite this, people made ends meet and found budgeting and cash flow management critical to financial success. Some things get old and tired and some things are old and golden. Budgeting and cash flow management are the latter. They are tried and true ways to live a healthy financial life.”

A. – Richard Barrington, commentator on business and financial developments for MoneyRates.com:
“This is hardly ever worth it. Think of all the negatives described above, and then add the tax consequences from a hardship withdrawal – typically, your normal income tax rate plus a 10% penalty.”

A. – Larry Heller, Enrolled Actuary, Director of Employee Benefit Services for Becher, Della Torre, Gitto & Co., CPAs:
“401(k) plans differ in their leniency towards withdrawals of employee contributions during employment, though all must be limited to hardship circumstances. But the most common hardship withdrawal provision – whether it only covers the employee’s own money in the plan or also the company’s contributions – requires the participant to be able to substantiate that the amount being requested is solely for the purchase of a primary residence, post-secondary school education, unreimbursed medical expenses, prevention of eviction, or funeral expenses, and that the requested amount can’t be provided by a loan or non-hardship withdrawal from the plan.

“Unless any of the money being withdrawn is from contributions that have already been taxed, the withdrawal is taxable. And, if made prior to age 59.5, the withdrawn amount is also subject to the same 10% additional tax mentioned above. Hardship withdrawals also require the employee to suspend their contributions to the plan for the next six months, thereby costing them the tax benefits of those contributions as well as any company matching contributions during that time.”

Q. – What are the potential consequences of borrowing from your retirement funds?

A. – Richard Barrington, commentator on business and financial developments for MoneyRates.com:
“I can think of three problems with borrowing from a retirement fund:
•    You shortchange the investment of your retirement account. A retirement savings program is typically predicated on building a retirement nest egg in two ways – from contributions to the account, and from the investment growth of those contributions. Over time, that investment component is extremely important, and once you start borrowing from the account, you are taking the investment component out of the equation for the amount you borrow, for as long as it is out of the account.
•    There’s a risk the borrower (you) won’t be able to pay the money back. People often find themselves in financial difficulty because of unsustainable spending habits. Borrowing from a 401(k) can be a way of continuing those habits for a little longer, without addressing the real problem.
•    There may be a bankruptcy risk. I’m not a legal expert, but I believe 401(k) assets are protected from creditors. Once you pull money out of the 401(k) plan, even in the form of a loan, it’s fair game.”

Q. – If you must borrow from your 401(k), what must you do to guarantee you don’t mess up your future?

A. – Mackey McNeill, CPA/PFS, member of the AICPA’s National CPA Financial Literacy Commission:
“Budget! Do a cash flow analysis on your current spending and find the pot holes. Make clear, conscious healthy choices about spending by putting yourself on a budget. The budget isn’t a harness; it is a tool to give you the freedom to reach your goals. Loan repayment for your 401(k) is included in your budget.”

A. – Richard Barrington, commentator on business and financial developments for MoneyRates.com:
“You should only do it if you have a short-term (i.e., less than six months) and iron-clad plan for repayment.”

A. – Larry Heller, Enrolled Actuary, Director of Employee Benefit Services for Becher, Della Torre, Gitto & Co., CPAs:
“Be aware of the loan’s interest rate and the plan’s repayment opportunities, if any, for former employees. Of course, be aware of your own ability to prepay the loan should you leave the company, and even your ability to take a second loan from the plan if you don’t. Don’t take an arbitrary and small loan from a plan that only permits one at a time, especially if you foresee the need for a more significant loan in the near future and aren’t allowed to pay off the first loan early. Be aware of whether your plan allows for early prepayment of the loan, perhaps to allow you to take another (larger?) loan. Other than loans for home purchases, which some plans allow to be repaid beyond five years, all 401(k) loans must be repaid within five years. Be careful of large loan amounts being repaid over short periods of time. Plan permitting, participants can generally borrow up to 50% of their account balance, up to $50,000. The repayments on a $50,000 loan repaid over just five years will take a healthy bite out of one’s paycheck.”

***

“The shift over the past 25 years from defined benefit pensions to defined contribution retirement programs like 401(k) plans is going to cause a lot of people retirement hardships,” says Richard Barrington, commentator on business and financial developments for MoneyRates.com. “Even so, you will still find people who insist that the personal control they get from a 401(k) plan is worth it. However, it only has a shot at working out if you don’t view your 401(k) balance as a piggy bank for borrowing or even as an ‘emergency account’ for hardship borrowing.”

About the Experts:

Richard Barrington is a commentator on business and financial developments for MoneyRates.com. He has over a quarter century of investment, marketing, and professional writing experience. During his investment advisory career, he served in a variety of senior management capacities. More recently, he has published articles on a variety of business topics, including mortgages, interest rates, investments, marketing, and management. For more information, please visit www.money-rates.com.

Larry Heller, Enrolled Actuary, Director of Employee Benefit Services, is an Associate of the Society of Actuaries.  He joined BDG in 2006 after a distinguished career with many of the leaders of the benefits consulting industry  –  as a Principal and Director in the retirement administration and consulting practices of Kwasha Lipton, Mercer, PricewaterhouseCoopers, and Buck Consultants.  Larry is a graduate of Brown University with over 25 years of experience in the design, administration, and communications of company-sponsored benefit plans.  He has spoken frequently at benefits conferences, authored numerous articles, and was cited by HRO Today magazine in 2005 as one of the nation’s leaders among human resource outsourcing advisors. For more information, please visit www.bdgcpa.com.

Mackey McNeill is CPA/PFS, member of the AICPA’s National CPA Financial Literacy Commission. McNeill is the President/CEO of Mackey Advisors™ CPA’s & Wealth Advisors. She founded Mackey Advisors™ CPA’s & Wealth Advisors in 1983 and it is the largest women-owned businesses in Greater Cincinnati. For more information, please visit www.cultivatingprosperity.com.

Filed under: Retirement Risks on February 21st, 2010