Understand risks, costs of 401(k) hardship withdrawal

McLEAN, Va. (3/17/08)--Homeowners facing foreclosure are raiding retirement funds to stay afloat, often without understanding the severe financial consequences of their actions (USA Today March 11).

Typically, you can't get your hands on 401(k) monies unless you retire, leave the company, or become disabled. Some companies, though, permit hardship withdrawals if you have an immediate financial need, including the purchase of a home. These withdrawals require that you pay taxes and penalties--usually in the year you take the money out--on the money withdrawn.

Another option is to borrow against your 401(k); you pay interest on the loan, but the interest goes back into your account.

Recent reports document a disturbing trend. A survey by the Transamerica Center for Retirement Studies revealed that 18% of workers had outstanding 401(k) loans in 2007, up from 11% in 2006 (MSNMoney.com March 7). Fidelity Investments and T. Rowe Price Group also reported increases in loans and hardship withdrawals in 2007.

Based on a sampling of hardship withdrawal applications filed in January, Merrill Lynch found that the primary reason for the request was to prevent foreclosure or eviction. And Principal Financial received 245 calls in January from participants asking about hardship withdrawals, compared with 45 similar calls in January 2007.

Although a hardship withdrawal or loan against your retirement account appears as a seemingly quick solution to financial problems, using a 401(k) like a piggy bank has long-term--and expensive--implications.

Contributions may be barred. About 85% of employers won't let you make 401(k) contributions for six months following a hardship withdrawal.

Funds withdrawn for financial hardship lose benefits of compounding. As a result, your nest egg will be smaller when you retire.

Withdrawals before age 59 1/2 incur penalties. On top of the taxes owed, you'll pay a 10% early withdrawal penalty on retirement funds.

Job loss means immediate payback of loan. If you lose or change your job, the loan against your 401(k) is due in full before you leave, or you'll face taxes and potential penalties. If you can't pay the loan back in time--sometimes within 60 days--it's considered a withdrawal and subject to taxes and penalties.

Loans can't be rolled over to a new employer. Unlike 401(k) accounts, which usually can be rolled over into a new employer's plan without penalties, loans against your 401(k) cannot.
Another loan, another payment. If you're already experiencing financial difficulty, you're just adding to your debt payments.

For more information, read, "401(k) Distribution Options for Retirees" in Plan It: Retire Ready Toolkit.

courtesy of cuna.org