Feature Articles
Hardship Withdrawals Give Access to 401(k) Savings, But at a Cost
By Clifton Linton
Senior Writer, mPower

 

If you're in a financial pinch, you might be able to tap your 401(k) for a bailout -- but it could really cost you.

Mike Quaid, 46, found this out the hard way. Needing $17,000 for a down payment to buy a house, Quaid took a hardship withdrawal from his 401(k) savings last May. Today, he's a happy homeowner but a fretful taxpayer. The reason: he faces hefty taxes and penalties on his 401(k) withdrawal.

He's got some spare cash that he'd like to use to repay his 401(k).

"Can I put this money back into the account? If so, when would it have to be put back in to avoid paying the taxes and early withdrawal penalty?" he asked.

Sorry Mike. You can't put the money back, and you still owe those taxes and penalties.

Quaid is not alone in tapping his retirement savings. The weakening economy and onset of the holidays seem to have many thinking about taking this money. Ted Benna, creator of the first 401(k) plan and author of a reader Q&A column on this Web site, acknowledged that readers have been asking more questions about hardship withdrawals in recent weeks, although this doesn't necessarily mean more people are actually making these withdrawals.

"It is safe to say that (hardship withdrawal information) is one of the things being asked more frequently by readers," he said.

And that has some financial and retirement industry experts worried. A withdrawal taken in haste today could have a big impact on your golden years.

Hardship Basics

A hardship withdrawal is not like a plan loan. The withdrawal may be difficult to get, and costly if you receive it. Remember, your 401(k) is meant to provide retirement income. It should be a last-resort source of cash for expenses before then.

Knowing that workers would resist putting aside money for decades with no chance to access it, IRS rules allow plan withdrawals in a limited number of hardship situations. Quaid's home purchase qualifies as one.

 

"It is safe to say that (hardship withdrawal information) is one of the things being asked more frequently by readers."
Ted Benna, creator of the first 401(k) plan

 

To further discourage early withdrawals, in some cases the IRS imposes a hefty financial penalty.

Two types of hardship withdrawals are permitted from 401(k) plans. One is called a financial hardship withdrawal. It is subject to applicable income taxes and a 10 percent early withdrawal penalty if you are younger than 59 1/2.

The other is a penalty-free withdrawal made under Section 72(t) of the Internal Revenue Code. With this, you pay applicable income taxes but not an early withdrawal penalty.

Financial hardship withdrawals are allowed for the following reasons:

 

 

You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:

 

 

Employers are not required to offer either type of hardship withdrawal, so you should check with your employer to see which type, if any, is available to you. This article primarily discusses financial hardship withdrawals.

Withdrawal Process

If you need a new car and want to take a 401(k) hardship withdrawal for that purpose, think again. These withdrawals are meant for big emergencies. You really have to need the money and have no other source of funds.

In addition to tough federal rules, you may also have to contend with a strict set of withdrawal rules from your employer.

That said, some employers are easing the rules to make the hardship withdrawal application process easier and give plan participants faster access to their cash, said Leslie Smith, a partner with Deloitte & Touche and the coordinator of the firm's annual 401(k) plan survey.

Employers use one of two methods to issue financial hardship withdrawals. One is a proof of need. In this case, you have to show your employer financial proof that you need to take money out of your 401(k). With this method, you are allowed to start contributing to your 401(k) plan with the next paycheck following your hardship withdrawal.

 

"Once you take the money out, you can't put it back in. You lose for life the tax advantage."
Deborah Knuckey, author of "Conscious Spending for Couples"

 

Many employers don't use this method, Benna says, because they really aren't interested in knowing so much about their workers' private lives. Similarly, few workers are comfortable exposing their finances to their bosses and co-workers.

The other method, called self-certification, doesn't require you to disclose your finances, but plans using this method will not allow you to make fresh 401(k) contributions for six months after taking the withdrawal. This further limits your ability to build a retirement nest egg.

Loan Alternative

By the end of the year, Quaid found he had some extra cash on hand and wanted to know if he could repay the hardship withdrawal or roll the money into an IRA and avoid the taxes and penalties. The answer is "no."

"Once you take the money out, you can't put it back in," said Deborah Knuckey, author of Conscious Spending for Couples. "You lose for life the tax advantage."

A hardship withdrawal is not a loan. You can't repay it. But, that raises a good point. You should see if your plan offers a 401(k) loan as an alternative to taking a financial hardship withdrawal. Plan loans are not subject to taxes or penalties, and you can continue to contribute to the plan while you repay the loan. (Some plans will even require you to exhaust your possibilities for a loan before taking a hardship withdrawal.)

However, if you leave your employer before the loan is repaid, you must pay back the remaining balance otherwise it will be considered a withdrawal and subject to applicable taxes and penalties.

When looking for hardship withdrawal alternatives, don't forget savings in your IRA, if you have one. IRS rules allow IRA holders to withdraw up to $10,000 penalty-free when the money is used for qualified first home expenses. (That is a lifetime limit.) Also, you may take penalty-free IRA withdrawals when the savings are used to pay for qualified higher education expenses for you or your spouse, children or grandchildren.

Tax Pain

What many 401(k) participants, desperate for money, may forget is the cost of taking a financial hardship withdrawal. A $10,000 withdrawal does not equal $10,000 in your pocket.

"If you are under 59 1/2, you will lose 35 percent to 45 percent of the withdrawal in taxes and penalties," Benna said. "You need to think about that."

For example: suppose your tax filing status is married filing jointly and you earn $60,000 a year. That means your income falls in the 27 percent tax bracket.

If you take a $10,000 hardship withdrawal to pay for your child's college tuition, you will owe $2,700 in federal income taxes and an additional $1,000 to cover the early withdrawal penalty. You'll be left with $6,300, or less if you also owe state income tax.

Retirement Pain

Taking a hardship withdrawal can also result in longer-term pain -- a less generous retirement.

Take the example of a person who, starting at age 30, contributes $5,000 a year to her 401(k) plan. At age 40, she buys a house and takes a $10,000 hardship withdrawal for the down payment. Let's assume her portfolio generates an average annual return of 8 percent. By retirement at age 65, she will have $793,094. Had she not taken the hardship withdrawal she would have had $861,584, or $68,490 more.

A $10,000 withdrawal may seem insignificant today, but over time it can mean a lot. The trouble is making up for it in the account.

"Few people take money out and make the promise to put it back in," said Diane Savage, a certified financial planner with Szarka Financial Management. Even if they do, by the time they get around to it, it's more costly to get the account back to where it should be. That's because the money wasn't working for them while it was out of the account.

"Say you are taking $10 out of the account. You would need to put back in $15 to make up for the time value of money," Savage said.


Bullet.gif (834 bytes)Article Archives



The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
mPower is the premier online community resource for 401(k) participants
Copyright ý 1996 - 2000 mPower. All Rights Reserved.