According to Fidelity Investments, in the second quarter of 2010, a record number of workers requested hardship withdrawals from retirement plans administered by the company.
True, the estimated 62,000 who did so are a small portion of the overall number of participants in plans administered by Fidelity. But the figure still represents a 38 percent increase over those who cashed out in the same period of 2009.
If your clients are considering liquidating their at-work retirement plans, here's what they should know about the costs and consequences, as well as some preferable alternatives.
The Rules
Retirement plan participants who want to tap their at-work accounts before quitting or retiring have to follow regulations established by both their employer and the IRS. The language in the employer's plan document determines if hardship withdrawals will be allowed, and if so, what circumstances experienced by the employee will qualify (for example, unreimbursed medical expenses).
Even if a cash-out is kosher with the plan rules, the employee then has to answer to the IRS. The law says the employee's need must be “immediate and heavy,” which can include:
- Certain medical expenses.
- Purchase of and repairs to a principal residence.
- Avoiding eviction or foreclosure.
- Tuition and education expenses.
The law also requires the employee to exhaust all other available options, such as borrowing from the account instead of liquidating it. Finally, the employee can usually only get contributions out via a hardship withdrawal, not account earnings.
Paying the Price
Once the employee gets past the boss and the IRS, there is the matter of taxes and penalties. Hardship distributions from pre-tax retirement plans — like 401(k)s and 403(b)s — are taxed as ordinary income to the employee, and piled on top of the worker's regular taxable income.
Then there is a 10 percent penalty imposed by the IRS if the worker is under age 59½, which is added to the tax on the money withdrawn. All told, it means a middle-income worker taking $10,000 in a hardship withdrawal could end up paying $4,000 or more in taxes and penalties. In a small sign of mercy, the IRS allows the inherent taxes and penalties to qualify as legitimate expenses to justify a hardship withdrawal.
Also, there are five instances in which the 10 percent penalty (but not the taxes) can be avoided:
- Total and permanent disability.
- Unreimbursed medical bills exceeding 7.5 percent of adjusted gross income.
- Court-ordered family support payments.
- Permanent loss of job after reaching age 55.
- Payments made via a 72(t) schedule of withdrawals.
To make the process even more burdensome, there's no guarantee that the employer will “rubber stamp” the withdrawal. The client may be required to provide proof that the hardship exists, and that the client has already exhausted all other options.
Since the client may only be able to use a hardship withdrawal as a last resort anyway, it's a good idea for you to consider where else the money might come from first.
401(k) Loan
If the plan rules allow it, the client can usually borrow the lesser of $50,000 or 50 percent of the retirement account balance for any reason, and with little paperwork or headache. The cost is low, but still considerable. First, the borrower pays interest on the loan, usually the prime rate plus a percent or two. But at least he is paying interest to himself.
There is no tax or penalty on the initial loan proceeds, but the client does have to repay the loan with after-tax, non-deductible dollars. However, if the client quits or gets fired while he still has an outstanding loan against his retirement account, the balance is usually due immediately. If he can't repay it, it becomes a hardship-like distribution, with all the ensuing taxes and penalties applied.
Roth IRAs
The IRS lets Roth IRA owners withdraw the contribution portion of the account at any time, for any reason, with no taxes or penalties whatsoever. The owner gets to designate any withdrawals as “contributions,” until the money taken out equals the amount deposited.
If there are any earnings left over and the client is under 59 ½, taking that portion out could trigger income taxes and a 10 percent penalty — but only on the earnings portion.
The 10 percent penalty on pre-59 ½ withdrawals of Roth IRA earnings can be avoided in some circumstances, such as higher education expenses, purchases of a first home, disability, and medical expenses — including purchase of health insurance if the client is unemployed.
IRAs
Those same exemptions to the 10 percent penalty apply to all withdrawals made from regular IRAs made by clients who are under age 59 ½. But even if the client can't avoid the penalties or the taxes, it still may be better for him to take the money out of his IRA, instead of getting a hardship withdrawal from an at-work 401(k).
First, as long as he is willing to pay all the taxes and penalties, he can take whatever he wants from his IRA whenever he wants, and for any reason. This flexibility and discretion is vastly preferable to seeking the approval of employer and the IRS.
Second, he can manage the withdrawals according to his needs, rather than the rules of his at-work retirement plan and the IRS. By spreading the withdrawals out over multiple years, he may be able reduce the overall taxes paid.
Life Insurance
The accumulated liquid amount in a cash-value policy can be a tempting source of funds for a client facing a financial crisis — especially compared to the hurdles of getting at money in a 401(k). But before the client cashes out of the policy, he should know that he may trigger penalties from the insurer, and taxes from the IRS that will reduce his net amount.
In the likely event a loved one would suffer financially from the client's death, he should replace the liquidated cash value policy with a cheaper alternative such as term life insurance — and this should be completed before he cancels the cash-value coverage.
College Savings Accounts
If the client owns any 529 qualified college savings accounts, he may want to consider tapping those before taking a hardship withdrawal from his 401(k).
Yes, there will be taxes and penalties imposed if there are no qualified higher education expenses incurred in the year in which the money is withdrawn. But the taxes and penalties only apply to the earnings portion of the account. Chances are if there has been any profit made in a 529, it's a relatively small portion of the total amount — and the fraction that will go toward taxes and penalties is even smaller.
Back to the Bank
Even if the client's last source of liquid assets is his 401k or 403(b), he should still get a “no” or two from local banks and credit unions before incurring the harsh penalties that a hardship withdrawal may bring.
He may be able to borrow or refinance his mortgage, either through the assistance of the lender, or through one of the government-sponsored programs detailed at www.makinghomeaffordable.gov.
He could also get an unsecured consumer loan, or loan against a paid-for vehicle. The interest rate is likely to approach double-figures, but it will still be less than the taxes and penalties he will pay if he taps his retirement plan assets while still working.
Avoiding the Nightmare
Clients who haven't yet reached a financial crisis can take several steps now to ensure one doesn't force them to choose between bankrupting their retirement account, or declaring bankruptcy.
They should establish and maintain a home equity line of credit for as much as their lender will allow, and keep a mental “EMERGENCY USE ONLY” seal over the account.
Better yet, they should re-establish a new fixed-rate, 30-year mortgage for the maximum amount possible, and then safely tuck away any cashed-out proceeds into a low-risk certificate of deposit that can be accessed with little or no penalty.
In a worst-case scenario, clients can draw upon the CD to cover mortgage and living expenses while they get through the crisis. If they never experience a personal crunch, they may still profit from locking in a long-term loan at an historically-low rate.
Finally, they may want to rethink how wise it is to put all of their liquid and retirement savings with their employer, especially one who has put in high hurdles to getting at the employee's own money when the employee needs it the most.
Not only will the client with a self-directed retirement account get easier access to his retirement money, but he will also have a much wider range of investment options at his disposal.
He can still defer up to $5,000 per year in pre-tax savings in an IRA ($6,000 if he's over 50), and an equal amount for his spouse.
And if he doesn't want or need the tax-deferral, he can use a Roth IRA to guarantee immediate, friction-free access to the contribution portion of the account. Left untouched, in his retirement his Roth IRA will help avoid paying any taxes on the withdrawls. Those savings could exceed even the most burdensome penalties and tax rates applied to income today.