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It's pretty satisfying to get your 401(k)
statement in the mail and see the good-sized balance that you've built. After
contributing for several years, it's becoming easier to imagine all of the things that
you'll be able to do with that money when you retire.
Then the doctor bill comes, or the tuition
bill, or a late notice from your mortgage company. Suddenly, the pie-in-the-sky picture of
retirement seems meaningless in the face of your current problems. So, can you access that
401(k) money to cover these sorts of hardships?
Yes, if your plan allows it.
To get at the money, however, you'll have to weave your way
through a veritable obstacle course of regulations. You'll need to prove that you really
need the money right now, says Jim Stone, a Chartered Financial Consultant (ChFC) and an
instructor at the College for Financial Planning. "The financial hardship provision
allows withdrawals only for immediate, pressing need," said Stone.
Reasons that people apply for hardship withdrawals vary
from the whimsical, such as a trip to the Caribbean (which won't be approved), to
the agonizing, such as paying for a child's leukemia treatment (which probably will). But,
there are only four IRS-approved reasons for making a hardship withdrawal: college tuition
for yourself or a dependent, provided it's due within the next 12 months; a down payment
on a primary residence; unreimbursed medical expenses for you or your dependents; or to
prevent foreclosure or eviction from your home.
It should be noted that, if your plan permits, you can take
a loan from your 401(k). And, while you can avoid penalties and taxes with loans (with a
hardship withdrawal you can't), they must be paid back.
Forty-eight percent of the people who have taken a hardship
withdrawal have done so to buy a home, according to a study conducted by the Investment
Company Institute (ICI) in the spring of 2000. Other reasons cited were medical emergency
(28 percent), bills or daily expenses (21 percent), and education (7 percent).
If you are exploring the idea of using the hardship
withdrawal provision, make sure that you aren't making the decision lightly. Financial
planners consistently stress that your 401(k) account does not work very well as a savings
account or emergency fund — the money is hard to get, the process is time consuming,
and the damage you can do to your retirement savings account can take many years to
repair.
The Approval Process
Before you begin: You will be in for a lot of
paperwork if you decide to take a hardship withdrawal. Before beginning the process, you
might consider discussing your financial situation and options with a financial planner.
The legally permissible reasons for taking a hardship
withdrawal are very limited. And, your plan is not required to approve your request even
if you have an IRS-approved reason.
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| IRS-approved Reasons |
The IRS allows hardship withdrawals for only
the following reasons:
- College tuition for yourself or a dependent, provided it's
due within the next 12 months;
- A down payment on a primary residence;
- Unreimbursed medical expenses for you or your dependents; or
- To prevent foreclosure or eviction from your home.
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How it works: If your plan allows hardship
withdrawals, your request will need to be approved either by a committee or a designated
representative who has agreed to accept the legal responsibility for making the decision.
Because there are a lot of legal issues surrounding hardship withdrawals, the approval
process can be very strict; these are rarely "rubber stamp" decisions.
If the plan administrator allows frivolous withdrawals,
"it's a plan-level problem that could result in the plan being disqualified,"
said Stone. Each plan that allows hardship withdrawals is required to spell out its own
rules in the plan document. These rules can be tougher than the federal guidelines.
You may be required by your plan to explore several
alternatives before you are approved, such as an IRA withdrawal or a commercial loan. Many
plans require you to provide some sort of proof to document your financial need. This can
include financial statements, eviction notices, or a notarized statement from an
accountant. "Hardships are strictly for immediate and very heavy financial
burdens," said Stone.
Remember that when you've been approved for a withdrawal,
you're not off of the IRS radar screen. A hardship withdrawal is a taxable event, so you
will have a mandatory 20 percent withholding tax taken out of the check. You may end up
owing more, depending on your total income for the year. You may also be subject to the 10
percent penalty if you are under age 55.
The Pain of Paying Penalties
The tax burden on early withdrawal hits you in two
different ways. First, your withdrawal is subject to ordinary income tax. For example, if
you normally pay 28 percent federal tax and 4 percent state tax, then a $10,000 hardship
withdrawal will lose $3,200 to the government.
Second, your withdrawal may be subject to a 10 percent
early withdrawal penalty on the full amount. The only reason you wouldn't pay the penalty
is if you are over age 55 or if the IRS grants you an exemption. Even though, in our
example, you are paying $3,200 in taxes already, you still pay the 10 percent penalty on the
full amount, or a penalty of $1,000. Put these two numbers together and you can see
that the $10,000 withdrawal only leaves you with $5,800 after taxes. On average, you'll
pay between 25 percent and 40 percent or more in taxes and penalties from your
hardship withdrawal, according to retirement expert Ted Benna.
"These kinds of withdrawals are a very real loss to
your retirement goals," said Stone. "When you use investment dollars today, you
are also using the future gains that the money could have earned. It could have a very
sizeable impact."
Will My Retirement Plan Survive?
While it may not be your primary concern at the time, the
withdrawal will hurt your retirement savings in several ways. Your withdrawal will cost
you not only the taxes on the money you take out, but also the compounded earnings that
you would have made on that money. Plus, when you take a hardship withdrawal, you won't be
allowed to contribute to your tax-deferred retirement plan for 12 months.
For example, a person who began contributing $5,000 per
year at age 30 and took a hardship withdrawal of $10,000 at age 40 will have missed out on
$173,355 at age 65, assuming a consistent 10 percent annual return. That amount could give
you an annual income of between $10,000 and $15,000 for 20 years after retirement,
depending upon how it was invested.
If your financial situation has been so difficult that
you've needed a hardship withdrawal, it probably isn't a bad idea to take some time
rebuilding your short-term savings after you've dealt with the crisis. Most financial
planners say that you need three to six months worth of income in liquid short-term
investments, like savings or money market accounts.
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"If you take a hardship
withdrawal for a home purchase, try to do it at the beginning of the year, so that the tax
benefits of home ownership for a full year help offset the downside of an early 401(k)
withdrawal."
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| — Ted Benna,
creator of the first 401(k) plan. |
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Repairing the Damage
After taking all of this into consideration, if you still
want to take a hardship withdrawal, there are ways you can mitigate at least some of the
negative effects it can have on your retirement account. After all, there is no sense in
turning your current financial crisis into a second crisis in retirement. Some ways to get
back on track include:
- Increasing the amount you would normally defer once you
resume making contributions.
- Putting money into an IRA if you recover financially from
your crisis before you are eligible to contribute to a defined-contribution plan.
- Making a catch-up contribution, if you are using a 457 or
403(b) plan for retirement savings.
- Taking on a little more risk in your account. Review your
asset allocation.
- Taking a hardship withdrawal for a home purchase at the
beginning of the year, so that the tax benefits of home ownership for a full year help
offset the downside of an early 401(k) withdrawal, says Ted Benna.
These methods may not fully recover the loss incurred by
your withdrawal; however, restoring to your retirement account(s) the income you withdrew
is an important element in achieving your overall retirement goals. |
