A housing market that has not recovered from the big price drops that began several years ago, long-term unemployment, and a still wobbly economy mean tough times for cash-strapped individuals seeking to raise money for an immediate financial need. Compounding the misery is the fact that many people have locked away the lion’s share of their savings in a tax-favored retirement vehicle, such as a company profit-sharing or 401(k) plan, IRA, SEP, SIMPLE IRA, or Roth IRA. And getting at that money in order to resolve a pressing financial crisis before 59 1/2 years of age is not easy and can be financially painful.
In general, tapping into a profit-sharing plan, IRA, SEP, or SIMPLE IRA requires a taxpayer to pay the tax on the amount withdrawn and, unless a taxpayer meets one of the limited exceptions, a 10% early withdrawal penalty. To make matters worse, if the taxpayer lives in a state with an income tax and possibly a state early withdrawal penalty, the overall amount of the withdrawal that goes to pay taxes and penalties can approach 50% of the amount withdrawn. (Note: Certain amounts of Roth IRAs and some Traditional IRAs can be withdrawn without paying tax or penalty).
There are generally only two ways for active employees who are under 59 1/2 years of age to tap into their account balances in 401(k) plans: take a loan from the plan or take a hardship withdrawal, if they are eligible to do so. But just because the plan may permit a withdrawal for hardship does not mean that the withdrawal will avoid either being taxed or subject to the early withdrawal penalty.
401(k) Loans—Borrowing money is not considered a taxable event since it is merely a loan. However, loans must be paid back, and if a taxpayer subsequently defaults on a 401(k) loan, the loan becomes a taxable distribution that is subject to tax and penalties. An often-overlooked hazard to a 401(k) loan is the possibility of leaving employment with the plan’s sponsoring employer, at which time the loan would need to be paid in full or it would become a taxable distribution that is subject to the usual penalties.
Hardship Distributions—The law places limits on distributions to participants of 401(k) and similar plans, which are usually granted when the employee separates from service (retires, changes jobs), dies, becomes disabled, or reaches 59 1/2 years of age. For some plans, a hardship distribution may be permitted. A distribution is treated as made after an employee’s hardship only if it is made on account of the hardship, which in turn requires the distribution to be:
- Made on account of an immediate and heavy financial need of the employee; and
- Necessary to satisfy that financial need.
What is an immediate and heavy financial need? According to IRS safe harbor rules, a distribution is treated as made on account of an immediate and heavy financial need if made for:
(1) Expenses for (or necessary to obtain) deductible medical care (which includes expenses for the care of a spouse or dependent);
(2) Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
(3) Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children, or dependents;
(4) Payments necessary to prevent the employee’s eviction from his or her principal residence or foreclosure on the mortgage on that residence;
(5) Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children, or dependents; or
(6) Expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction.
Maximum Distributable Amount—A hardship distribution cannot exceed the maximum distributable amount, which includes the employee’s total elective contributions on the distribution date, reduced by any previous distributions of elective contributions. It also may include employer contributions, depending on how those contributions are made (i.e., matching or non-elective) and how the plan is organized. Not all plans are the same; thus, the employer will need to be consulted.
Obtaining a hardship distribution from a 401(k) plan is not easy and should not be used as a means of rising needed cash if other sources are available. The plan participant should keep in mind that:
- The taxpayer’s definition of hardship may not correspond with the plan’s definition.
- If the plan uses the safe harbor method of treating a distribution as necessary to meet an immediate and heavy financial need, the plan participant will be barred from making elective contributions (and will therefore forfeit any matching contributions from the employer) for a period of at least six months.
- The taxpayer may need to take a loan from the 401(k) plan first before he or she can take a hardship distribution.
- Depending on how the plan is organized, the taxpayer may not be able to withdraw his or her entire balance.
- The taxpayer will lose the tax-deferred earnings buildup forever that would have accrued on the hardship withdrawal had it not been made.
- The taxpayer will have to pay tax at ordinary income rates on the withdrawal (assuming that he or she has made no after-tax contributions) and most likely a 10% premature withdrawal tax as well.
Using funds meant for your retirement can have long-term consequences that should be carefully considered. Before tapping into your retirement funds, we urge you to contact this office so that we can help minimize the damages and avoid penalties wherever possible.