Today’s economic environment can create a cash crunch when people face big expenses, such as unanticipated medical costs or the possibility of a home foreclosure. In many cases, credit card debt limits have been reached, and with declining home values, home equity loans may not be an option. Many are tempted to rely on what may appear to be the most readily available source of money: their 401(k) plan. Hardship withdrawals from workplace retirement plans are drawing more interest from investors.
Taxes and penalties may apply if you withdraw funds early, and there is little flexibility to avoid it. For instance, if you are in the 25 percent tax bracket, a withdrawal of $10,000 from your 401(k) will net you $6,500 in available cash after you pay taxes and a 10 percent penalty.
Because of that, and because of the fact that you should be doing all you can to preserve your retirement portfolio, it may be best to avoid early withdrawals from your 401(k). It is also important to note that withdrawals can only occur under specific circumstances. According to the IRS, an early withdrawal from a 401(k) qualifies as a hardship withdrawal if you are:
•Paying unreimbursed medical expenses.
•Purchasing a principal residence.
•Paying college tuition costs for certain family members.
•Making payments to avoid a home foreclosure or paying for home repairs.
•Covering costs of a funeral.
Even if you meet these conditions, you will not avoid paying tax and penalty on your withdrawals.
To preserve the integrity of your retirement plan and avoid the impact of taxes and penalties, you should consider alternatives to hardship 401(k) withdrawals to meet short-term financial needs. One option is to take a loan from your 401(k) plan. Check with your plan sponsor (your employer) to see if loans are an option within your plan. At the same time, use caution.When you borrow from your 401(k), you repay the loan at interest rates that are often tied to the current prime rate, but the amount you took out of the account is no longer generating returns in your investment portfolio. An important caution is to pay back the loan as quickly as possible. If your employment should be terminated, the unpaid portion of the loan is treated as a distribution, subject to taxes and possible penalties for early withdrawals.
Newhouse News Service