(RIVERWOODS, ILL., April 11, 2012) – Your retirement savings account is meant to grow while you’re working and many advise that pre-retirement withdrawals should only be taken as a last resort. That may be the final option for those who face circumstances where quick cash is needed, but it’s important to know the rules and consequences of drawing from retirement savings. CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com), takes a look at what you need to know before making the decision.
“Many people may not understand just how difficult and costly it can be to try to pull money from their retirement accounts prematurely,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA. “The rules for taking money out are very restrictive because these accounts are designed to be kept for retirement income; so people can be surprised when they can’t simply withdraw money, without consequence, to pay back rent or a few missed mortgage payments.”
Below, CCH answers questions on the different options and tax implications for tapping a 401(k) for needed funds. A video interview with Luscombe on what to expect if drawing funds from a 401(k) or another qualifying retirement account can be viewed here: 401(k) withdrawals/interview.
What are my options?
Taxpayers who want to tap their 401(k) accounts generally can take either a loan that must be repaid or a hardship distribution that does not need to be repaid, but is subject to income and penalty taxes. Specific rules apply in both situations and, if not followed, can result in fines and penalties, which can add to the person’s financial difficulties. Additionally, while many plans do allow participants to take hardship distributions or loans, they are not required to do so.
Which is easier to get?
It’s easier to qualify for a loan than a hardship distribution as employees generally can borrow from their retirement account balance for any reason, subject to their plan’s terms. In addition, an employee is not required to pay income tax or penalty tax on a loan, as long as it is repaid on time and with interest.
What are the requirements for applying for a loan from a 401(k)?
Three general requirements include:
- The amount of the loan can’t exceed the lesser of $50,000, or the greater of either one-half of the present value of the participant’s account or $10,000. For example, the maximum loan amount someone with $130,000 in 401(k) savings could take would be $50,000 (the maximum allowed); someone with $30,000 in 401(k) savings could take a loan of up to $15,000 (one-half their present 401(k) value); while someone with $15,000 in 401(k) savings could take a $10,000 loan;
- The loan (other than a loan used to acquire a personal residence) must be repaid within five years; and
- Loan payments must be made at least quarterly.
What are the penalties for not repaying the loan?
Penalties for not repaying a loan are stiff. If a participant misses a payment, it’s considered a deemed distribution of the loan balance. The employee is then subject to a 10-percent early distribution penalty and required to pay taxes on the amount of the loan. Some plans may allow a participant a special period in which to make a required installment payment.
Two exceptions from the general loan requirements include rules on loans for:
- A principal residence – Loan terms for buying a principal residence may provide for a repayment period beyond five years. However, neither home improvement loans nor refinancing qualify as principal residence loans; and
- Military personnel – A plan may (but is not required to) suspend an employee’s obligation to repay a loan during the period of the employee’s military service.
What if I leave the company or lose my job?
If an employee is let go or leaves his job, the plan can require accelerated repayment or convert the unpaid amount into a distribution, subject to income tax and possible penalty tax.
What are the requirements for taking a hardship distribution?
Hardship distributions taken from 401(k) savings do not need to be paid back. However, they can only be taken when the employee has an immediate and heavy financial need, the distribution is necessary to satisfy the need, and the distribution amount is not more than necessary to satisfy that need.
To comply with the rules governing 401(k) plans, most plans follow a safe harbor prescribed by the IRS that permits hardship distributions under defined circumstances, including:
- Medical expenses for the employee or the employee’s spouse, dependent and other beneficiaries, such as a sibling or domestic partner;
- Post-secondary tuition of employee, spouse, children or dependents for the next 12 months (not prior year);
- Costs related to the purchase of the employee’s principal residence;
- Costs associated with avoiding eviction or foreclosure;
- Burial or funeral expenses; and
- Expenses for the repair of casualty damage to the employee’s principal residence.
In addition, under the safe harbor, the employee must have obtained other currently available distributions, including plan loans (but not commercial loans), before qualifying for a hardship distribution.
What are the costs for taking a hardship distribution?
Costs of a hardship distribution can be significant. The distribution amount is generally included in the employee’s income and subject to income tax as well as the 10-percent penalty on early distributions.
One slight break is that while the amount of a hardship distribution cannot exceed the amount needed to address the hardship, it may include the amount needed to pay taxes or penalties resulting from the distribution – if authorized by the plan.
People also should factor in the missed opportunity cost of taking a hardship distribution. This includes the money removed from the retirement account. Additionally, the employee is not allowed to make elective deferrals to the plan and all other plans maintained by the employer for at least six months after receiving a hardship distribution.
The maximum amount people can contribute to their 401(k) plans for 2011 was $16,500 and $5,500 more as a catch-up contribution if they were 50 years of age or older. For 2012, the contribution amount increases to $17,000.
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is the leading global provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. Among its market-leading solutions are The ProSystem fx® Suite, CorpSystem®, CCH® IntelliConnect®, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill. Follow us now on Twitter @CCHMediaHelp. Wolters Kluwer (www.wolterskluwer.com) is a market-leading global information services company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands. Its shares are quoted on Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices.