401k Cash-Out For Loans vs. Hardship Withdrawals – Penalties and Taxes

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Despite a more stable economy, many Americans are still finding it hard to make ends meet and find that they are having to tap one of their most important and final saving vehicles – their company sponsored 401k or 403b (tax advantaged) retirement plans. There are 3 ways that cash can be taken out from a 401K account: A regular 401k loan, hardship or non-financial hardship withdrawal. Each is explained below with the applicable provisions.

401(k) Loan

The primary benefits of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default and no credit check is required to qualify. It is up to your employer and plan administrator (like Vanguard, Fidelity for larger corporate plans) to determine the minimum (normally $1,000) and maximum (up to 50% of balance) loan amounts. The government does not set guidelines or restrictions on the uses for 401k loans. The 401k loan must be paid back over the subsequent five years with the exception of home purchases, which are eligible for a longer time horizon. If you are married, your spouse will need to consent to the loan as well.

401k Loan Interest Expense – Even though you’re borrowing from yourself, you still have to pay interest on the loan amount. Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit to your retirement account is that you will eventually get this money back in the form of qualified disbursements at or near retirement, and the interest you pay back into your 401k plan is tax-deductible.

The biggest disadvantage of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results. Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.

Hardship withdrawal

If you cannot take out a 401k loan, you may still be able to get a hardship withdrawal from your plan. Many 401k plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs, but the IRS has strict guidelines as to what the funds can be used for. To qualify for a hardship withdrawal, you must demonstrate (with supporting evidence) to your plan’s administrator that the withdrawal is necessary due to an immediate and severe financial need which cannot be funded elsewhere. You must also confirm that the loan does not exceed the amount of the need (i.e. cannot borrow extra) and you have already obtained all distributable or non-taxable loans available under your 401k plan. If these conditions are met, the funds can be withdrawn and used for one of the following purposes:

- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments). Certain expenses relating to the repair of damage to the employee’s principal residence can also be justification for the withdrawal. Also, the new home buyer credit can still be claimed after the house is purchased.

- Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care.

- Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of post-secondary education for the employee, or the employee’s spouse, children or dependents.

- Payment necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.

- Burial or funeral expenses

All 401k hardship withdrawals are subject to taxes and the ten-percent penalty. This means that a $10,000 withdrawal can result in not only significantly less cash in your pocket (possibly as little as $6,500 or $7,500 if you are in a high income tax bracket), but causes you to forgo forever the tax-deferred growth that could have been generated by those assets. 401k hardship withdrawal proceeds cannot be returned to the account once the disbursement has been made, and in most cases you’re not permitted to contribute to your plan for six months after the withdrawal. The IRS also requires that the amount withdrawn be reported as gross income.

Non-Financial Hardship 401k Withdrawal

Although the investor must still pay taxes on non-financial hardship withdrawals, the ten-percent penalty fee is waived. There are five ways to qualify:

1. You become totally and permanently disabled

2. Your medical debts exceed 7.5 percent of your adjusted gross income

3. A court of law has ordered you to give the funds to your divorced spouse, a child, or a dependent

4. You are permanently laid off, terminated, quit, or retire early in the same year you turn 55 or later

5. You are permanently laid off, terminated, quit, or retired and have established a payment schedule of regular withdrawals in equal amounts of the rest of your expected natural life. Once the first withdrawal has been made, the investor is required to continue taking them for five years or until he/she reaches the age of 59 1/2, whichever is longer.

If you do need money from your 401K account, then a loan is preferable to a 401k hardship withdrawal because you start paying it straight back and incurs no penalties. As soon as your financial situation is more stable you should start contributing back into your 401K plan, which is the most tax efficient investment over the long term. Remember, your 401k is meant to provide retirement income,and should be a last-resort source of cash for expenses before then.

You can also withdraw funds early from an IRA and in many cases is more cost effective. For example, an IRA has a lifetime withdrawal exemption of $10,000 for a house with no strings attached.

References : IRS, About.com

Related:
~ What NOT to Do With Your 401K and IRA Retirement Plans
~ New Roth IRA Conversion Rules and Contribution Limits
~ Retirement 401k and IRA Accounts – Have You Rebalanced and Reallocated based on Changing Market Conditions and Contribution Limits?
~ How to Invest in the Stock Market via Stocks, ETFs and Mutual Funds

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