By Ellen Hoffman
You have several ways to withdraw money from your retirement ccount, but only one of them is designed to resolve an immediate financial crisis. It's called the "hardship distribution."
Currently, the government allows hardship distributions from your 401(k) for only four purposes: Medical expenses, purchase of your principal residence, tuition and related educational fees for college for you or certain family members, or to prevent eviction from or foreclosure on your home.
Because of a new law that goes into effect January 1, 2006, two more purposes will be allowed: to pay funeral expenses for your parents, spouse, children, or dependents, and to repair damage to your principal residence that occurs suddenly, from a one-time event such as a flood or hurricane. To qualify for withdrawals under the second situation, the damage would have to meet the IRS's definition of a casualty loss.
Because of Hurricane Katrina, the IRS announced last week that from now to Mar. 31, 2006, people who live or work in areas affected by the hurricane will be allowed to use the hardship distribution for other immediate needs, such as food and shelter. Also, at press time, both the House and Senate had passed a bill waiving the 10% penalty you normally must pay if you take a hardship withdrawal before age 59 1/2. But the waiver is only for hurricane victims and is applicable only up to $100,000.
In general, there are three strong reasons to avoid raiding your 401(k) before age 59 1/2 or before your retirement: You'll owe the IRS that 10% penalty tax just mentioned, you'll need to pay regular income tax on the amount withdrawn, and you'll lose the benefit of long-term compounding of the savings. If you're younger than 59 1/2, you can avoid the 10% penalty in a few other special situations the IRS calls "exceptions," including disability and high medical bills. You can read about the exceptions in this IRS document, under the heading "early distributions."
A hardship distribution, however, is more difficult to qualify for, requiring you to demonstrate an "immediate and heavy" financial need that you can't meet in any other way. And because of the potential long-term impact on your retirement finances, before assuming that a hardship withdrawal is the answer to any of your problems, you should take the time to understand all of the barriers that stand between you and that potential windfall.
First, employers aren't actually required to offer the hardship distribution in their 401(k) plans, so it may not be available at your workplace. To find out, ask your human-resources office or consult the "Summary Plan Document," a guide to your 401(k) plan that the employer is required to provide.
A survey by the Profit-Sharing Council of America, a trade association for employers who offer retirement plans, found that in 2003 nearly 91% of plans did allow the withdrawals. Hewitt Associates, a Lincolnshire (Ill.) human-resources consulting company, found in a 2004 survey that the average size of the hardship distribution taken was $5,419.
If your employer does allow the hardship withdrawal, you'll have to prove the "immediate and heavy financial need" with documentation such as a written notice of eviction or foreclosure on your home. Then you'll have to prove that you have no other potential sources of financial help.
YOUR LENDER, YOURSELF.
And that really means NO sources. An analysis of the rules by McKay Hochman Co., an employee-benefits firm in Butler, N.J., says assets such as a vacation home or a loan from a commercial lender are likely to prevent you from qualifying for the hardship distribution.
Finally, you also can't take the hardship money unless you've already borrowed 50% of the money in your 401(k). George Middleton, a Vancouver (Wash.) financial planner, points out that when you lend this money to yourself, you don't have to pay the 10% early withdrawal penalty. But you must repay your account, usually in five years. Although the finance charge may be relatively low, you'll forfeit the retirement savings growth you would have otherwise accrued.
Greg Plechner, a financial planner in Old Tappan, N.J., also warns that if you leave your employer before the loan has been repaid, there's a good chance that the company will require you to repay it quickly, perhaps in as little as 90 days.
Plechner suggests that if you're over 59 1/2 and still working, a more flexible way to tap your 401(k) is through an "in-service withdrawal," if your employer's plan allows this. It means following the strict rules for rolling money out of your 401(k) into an IRA. Plechner explains that you must initially transfer the funds to a rollover IRA. Then you can decide whether to convert the money to a traditional IRA or a Roth.
If you're already in a hardship situation, you'll most likely choose a traditional IRA, because with a Roth, you would have to pay income tax on the amount of money you put into the account. Once the funds are in the IRA, you may spend them for any purpose, as summarized in this IRS document.
If you can't solve your financial crisis by any other means, then ask yourself some tough questions about the real reason that you need this money. Middleton, who used to review hardship requests in his role as chief financial officer of a corporation, says many employees applied because of chronic inability or unwillingness to change their financial habits to live within their means rather than one sudden, unexpected financial blow.
The unfortunate victims of a catastrophe like Katrina, who truly may have lost everything else, may find that a 401(k) hardship distribution is their only current financial option. But the answer for others who are financially strapped may be a more long-term one: Reorganize your financial life to get out of debt, and create a plan that allows for a budget you can live with now, as well as some savings to count on for your retirement.
In addition to writing Your Retirement for BusinessWeek Online, Hoffman is the author of The Retirement Catch-Up Guide and Bankroll Your Future Retirement with Help from Uncle Sam. You can contact her through her Web site, www.retirementcatchup.com
Edited by Patricia O'Connell