Don’t Raid Your Retirement Plan

The subprime mortgage crisis continues to worsen as evidenced by the increasing withdrawals and loans taken from company sponsored retirement plans. For the first half of 2008, hardship withdrawals are up 21% over the same period last year. As the mortgage crisis deepens, the number of people seeking hardship withdrawals from their company retirement plan is likely to continue to accelerate. Most people are not aware of the rules or consequences but the results can be devastating to your retirement goals.

The Internal Revenue Service allows hardship withdrawals from Defined Contribution Plans, such as your 401k plan, for ‘immediate and heavy financial need’ but only after you have exhausted all other reasonably available resources including checking and savings accounts, loans available from your employer’s retirement plan, and assets from your spouse and minor children that are reasonably available.
Examples of qualifying hardships would include:
  • Expenses to prevent eviction or foreclosure of an employee’s principle residence.
  • Extraordinary medical expenses that would normally qualify as a tax deduction.
  • Costs of purchasing a principle residence excluding mortgage payments or refinancing.
  • Payment of tuition, fees and room and board for post secondary education for the employee, spouse, children or dependants. This is restricted to expenses for up to twelve months.
  • Payment for burial expenses for the employee’s parent, spouse, child or dependant.
  • Payments to repair damage to the principle residence due to natural disaster.
So the good news is that if you are in a significant financial pinch, you can take money out of your retirement plan. The bad news is that to do so can be extraordinarily expensive and is generally the financial choice of last resort. Here’s why. Money taken from your retirement plan under the hardship withdrawal rules are fully taxable as ordinary income. So you ‘stack’ the withdrawal on top of your other income, which can easily throw you into a higher income tax bracket. Further, if you are under the age of 59½, the federal government imposes an additional 10% penalty on all withdrawals. For example, you are 50 years old and you have regular taxable income of $65,000. To raise money to avoid foreclosure, you take a $40,000 hardship withdrawal from your company retirement plan. When you combine the federal and state income taxes with the federal 10% penalty, your total taxes would be approximately $16,000 netting you only $24,000. The hardship rules do allow you to ‘gross up’ the withdrawal to include taxes due on the withdrawal so as to ‘net’ the money needed. You will also have to document the exact amount of money needed and how it will be spent. I should also note that employers are not required to make hardship withdrawals and not all plans allow them.
The bottom line is that in desperate times, people often make poor decisions that seem appropriate at the time but which can have long lasting negative impact. Hardship withdrawals from your retirement plan, in most cases, would be one of those poor decisions. Once done, it cannot be reversed; the money cannot be returned to your retirement plan at a later date. If you are considering a hardship withdrawal from your retirement plan, be sure to get advice from your financial advisor before taking action.