Should You Take a Hardship Withdrawal?

March 27, 2017

If you are considering a hardship withdrawal, by definition you have a challenging, time-sensitive financial problem. You are probably feeling very worried and anxious about your situation. When money is tight, it is tempting to look to your retirement plan for resources to solve the problem.

Under certain limited circumstances, you may be able to access funds in your 401(k) or 403(b). However, just because you could withdraw funds doesn’t mean that you should do it. A hardship withdrawal should only be used as a last resort, in a truly urgent situation. Why?

It is expensive both now and later. You will pay income taxes on the amount you withdraw, as well as an additional 10% penalty if you are under age 59½. If the withdrawal is large, it could bump you up into a higher marginal income tax rate. Plus, you’re taking away funds which should grow to provide income in retirement for your future self. Here are some questions to help you to find the best choice for your situation:

1. Does this have to be paid right away?

Sometimes a need is urgent, very important and immediate. Some examples include preventing eviction or foreclosure, paying for medical treatment, or repairing your home after a natural disaster so you can live in it. In those cases, a hardship withdrawal for the amount of the need may be the only way you could stay in your home or get the care you or a family member needs. If the bill does not have to be paid all at once, such as a past-due medical expense or a home purchase you could defer, it may be better not to take a hardship withdrawal.

2. Do I have any other sources of funds?

Have you considered all your options? While your cash situation isn’t ideal, make sure you have thought about all things you could sell or places you could borrow from to raise funds:

  • Do you have any non-retirement investments you could liquidate such as stocks, bonds, or CDs even if it means you would take a loss?  Taking a loss on an investment is usually much less costly over the long run than withdrawing funds from your retirement plan.
  • Do you have a Roth IRA? If so, you can withdraw the contributions – but not the earnings – without taxes or penalty.
  • Can you borrow against your home equity or take a personal loan?
  • Do you have non-essential personal property you could sell to raise some cash? Some examples might include a second car, motorcycle, art, collectibles or jewelry.

3. Could you take a retirement plan loan?

Before deciding on a hardship withdrawal, explore taking a loan from your 401(k) or 4013(b). Many, but not all, employer-sponsored plans permit loans that allow you to borrow up to fifty percent of your vested balance up to a cap, whichever is less, for a one to five year period. Some plans also permit longer term loans for the purchase of a home.

The interest rate is usually low and paid into your own account, payments are deducted from your paycheck and it’s not reported to the credit bureaus. See here for situations when a retirement plan loan may make sense. A retirement plan loan has downsides, but they’re not as impactful as a hardship withdrawal.

4. Would the IRS consider your situation an allowed “hardship?”

A hardship is something that causes suffering or privation. The IRS allows hardship withdrawals from qualified retirement plans when the employee has immediate and heavy financial need, limited to certain:

  • Medical expenses incurred by you, your spouse or dependents
  • Payments to avoid eviction from or foreclosure of your primary residence
  • Post-secondary education expenses for you, your spouse, children or other dependents
  • Funeral expenses for you, your spouse, children or other dependents
  • Expenses to repair damage to your primary residence
  • Costs to purchase a primary residence

Note that credit-related needs such as satisfying payday loans, title loans or credit card debts are not covered under the definition, nor are tax bills or business expenses. See IRS guidelines here.

5. Are you taking out funds to purchase a home or pay tuition?

Finally, just because the IRS considers a home purchase or tuition payment a hardship does not mean it’s always wise to take a withdrawal for those reasons. A hardship withdrawal is meant for a true emergency. If the only way you can purchase a home is by taking a hardship withdrawal from your retirement plan for the down payment, you may not be financially ready yet to be a homeowner. As for tuition, consider exploring other options listed in #2 and #3 first, such as borrowing against your home equity or taking a retirement plan loan.

Once you’ve worked through these questions, if it seems like a hardship withdrawal is the best choice for you, know that you’ll have to go through an application process to move forward. You may be required to demonstrate heavy and immediate financial need, that you’ve considered a retirement plan loan but the payments would be burdensome, and that your financial need can’t be satisfied through other channels. Expect the process to take a few weeks.

If you do take a hardship distribution, you won’t be able to pay the money back and you may be precluded from contributing to your plan for six months. Your distribution will be included in your taxable income, plus you’ll pay an additional 10% penalty if you’re younger than 59 ½. If you have access, consider contacting your workplace financial wellness or employee assistance program for financial coaching, to help you put together a plan to manage your cash flow so you can get back on track.

 

Do you have a question you’d like answered on the blog? Please email me at [email protected]. You can follow me on the blog by signing up here, and on Twitter @cynthiameyer_FF.

 

 

How to Avoid Borrowing From Your Retirement Plan

January 26, 2017

Have you ever borrowed from your employer’s retirement plan? When you need cash in a hurry, it can be tempting. After all, you don’t have to worry about a credit check and the interest just goes back into your own account.

However, there are a couple of reasons why this may not be the best idea. First, you lose any gains your money would have earned. Keep in mind that the stock market averages a 7-10% return per year, including many years with double digit returns so you could be losing out on real money.

Second, if you leave your job before paying off your loan, the outstanding balance could be considered a withdrawal and subject to taxes plus a possible 10% penalty if you’re under age 59 ½. These losses could end up jeopardizing your retirement. Here are some ways to avoid having to raid your retirement nest egg in the future:

Don’t think of your retirement account as a giant ATM. Even if your plan allows it for any reason, retirement plan loans should only be for dire emergencies and no, wanting the latest tech gadget or a vacation doesn’t qualify. Instead, calculate how much you need to save each month and have that amount automatically transferred to a separate savings account until you have enough to purchase what you want. Don’t have enough to save? Ask yourself what expenses you’re willing to cut back on to make your goal happen.

Have an emergency fund. Even if you do have an emergency, a retirement plan loan shouldn’t be your first resort. If your investments are down in value, you may not even have enough to borrow. Instead, build up enough savings to cover 3-6 months’ worth of necessary expenses and keep that money someplace safe like a savings account or money market fund. If you can’t stand the idea of all that cash just sitting there earning less than 1%, here are some ideas to put it to work harder for you.

Consider other options. For example, the average home equity interest rate is about 5%. Don’t forget that it’s tax-deductible too. If you’re in the 25% tax bracket, that loan may only cost you 3.75% after taxes, which is less than your investments will probably earn. Just be aware that your home is on the line if you can’t make the payments so this is probably not be a good idea if you’re facing severe financial hardship.

One final point is that people sometimes use a retirement plan loan to pay down credit card debt. Given how high credit card interest rates can be, this might be a smart move if it’s part of a larger plan to become free of high-interest debt. However, if you end up filing for bankruptcy, you’ll still have the retirement plan loan. In that case, you would have been better off using the bankruptcy to wipe out the credit card debt and leave your retirement account alone. (It’s generally a protected asset in bankruptcy.)

Retirement plan loans have a place, but be aware of the downsides. If you’re not sure what to do, consider consulting with a qualified financial planner. As with any financial decision, you want to make an informed one.

 

 

 

 

We’re Not Talking About What’s Right. We’re Talking About The Law

March 18, 2015

One of my favorite TV shows of the 80’s was “WKRP in Cincinnati.” If you’re my age, you probably remember Johnny Fever, Venus Flytrap and of course Jennifer and the infamous Turkey Drop: http://youtu.be/lf3mgmEdfwg. As much as I loved that episode, my favorite quote came from another episode where Mr. Carlson is talking to the station’s attorney about a legal issue. When Mr. Carlson is talking about a situation that is morally wrong, he says, “That’s not right,” and the attorney responds, “Arthur, we’re not talking about what’s right. We’re talking about the law.” Continue reading “We’re Not Talking About What’s Right. We’re Talking About The Law”

How to Recover From a Credit Disaster

November 21, 2014

During one of my recent conversations with an employee, he was very disturbed by how much a bad credit score has impacted his life.He said that his credit score has caused his car insurance premiums to increase, he thinks it is hindering his job search (he may have a point because it is something that employers consider) and his girlfriend does not want to become his fiancée or wife until he shows significant progress in this area. So, he was very happy to have some ideas on how to make progress on repairing what was a very broken part of his financial life.  Continue reading “How to Recover From a Credit Disaster”

Using Retirement Plan Assets for Education

June 04, 2014

As the school year winds down, many graduating high-school seniors are looking ahead to the promise of a new day come next fall, but for many parents, that day is fraught with mixed emotions—and a handful of college bills. To help pay for college, some parents will set aside money using more traditional ways to save for college expenses. Each has its own set of pros and cons and seldom are parents able to save enough to pay for their student’s entire education. As such, many students will require student loans in order to continue their education. The result is an average student loan debt of just under $30,000. Continue reading “Using Retirement Plan Assets for Education”

Are 401(k) Loans a Really Bad Idea?

June 10, 2013

Following a recent financial planning webinar presentation, I was faced with a frequently asked question.  Does it make sense to take out a 401(k) loan to consolidate debt? This employee had definitely done her research on 401(k) loans but she was wary after reading warnings from many financial planners and media gurus. However, this didn’t deter her from exploring a 401(k) loan as she was eager to eliminate her high interest credit cards and get them out of her life forever.  Continue reading “Are 401(k) Loans a Really Bad Idea?”

What We Can Learn From 2012

March 13, 2013

Last week we released our 2012 Year in Review research, and there were several troubling statistics that came out of the report.  For starters, only 51% of employees reported having an emergency fund, which means there are 49% that are vulnerable to a financial setback should some unexpected expense come along.  Another troubling statistic was an increase in the percentage of employees that reported taking money out of their 401(k) as either a loan or hardship withdrawal.  Such early distributions can greatly impact if and when these employees will be able to retire.  As a result of sending out our research, we received the following three questions from a reporter: Continue reading “What We Can Learn From 2012”