This material was prepared for John Evans, LPL Financial Advisor, use.
Since the housing and stock markets collapsed several years ago, millions of Americans have found themselves in need of cash, either for short-term or longer-term expenses. Those who have contributed regularly to a workplace retirement plan, such as a 401(k) or 403(b), may find it tempting to tap into those accounts to help cover bills, either through a loan or a distribution. But before any preretirement withdrawal is made, it’s important to know the facts and consider the consequences.
Your decision should be influenced, in part, by the severity of your needs and the tax implications of the option you choose. Loans are not considered taxable distributions unless they fail to satisfy plan rules regarding the amount, duration, or repayment terms. But distributions (including hardship withdrawals) are generally taxable as ordinary income, and workers who receive retirement plan distributions before reaching age 59 1/2 may be required to pay an additional 10 percent early withdrawal penalty.
When considering a loan, there are several rules to keep in mind.
- The IRS generally limits the amount of a loan to 50 percent of your vested account balance, up to a maximum of $50,000.
- Most retirement plan loans must be repaid within five years, although loans used to purchase the participant’s primary residence may be paid back over a longer period of time.
- You may not be able to make new contributions to your plan until the loan is paid off. Additionally, loans are repaid with after-tax contributions, and interest (usually 1 percent or 2 percent above the prime rate) is due.
It’s important to remember that not all plans allow loans. A violation of any of the plan’s loan rules may cause the loan to be treated as a taxable distribution. Additionally, an employer may require participants who have taken a loan to repay the entire amount immediately upon leaving the company, regardless of the original repayment schedule. If an ex-employee fails to do so, the employer is required to report the loan to the IRS as a distribution.
Hardship: A Last Resort
The government has made the rules around applying for and receiving a hardship withdrawal of your retirement plan assets difficult for a reason: they want to ensure that the need for those funds is vital. Most plans only allow a hardship if all other means (including loans) have been exhausted.
Hardships can be taken if they meet certain requirements, including:
- Unreimbursed medical expenses for you, your spouse, or dependents.
- Purchase of a principal residence.
- Payment of college tuition and related educational costs (such as room and board) for you, your spouse, dependents, or nondependent children.
- Payments necessary to prevent eviction from your home, or foreclosure on the mortgage of your principal residence.
- Funeral expenses.
- Certain expenses for the repair of damage to the employee’s principal residence.
Ordinary income taxes (both federal and state, if applicable) are due on the withdrawal amount, but the 10 percent early withdrawal penalty may not apply in certain situations, such as when the distribution is made:
- Because of a qualifying disability.
- To pay medical expenses that exceed 7.5 percent of the participant’s adjusted gross income.
- To an alternate payee under the terms of a Qualified Domestic Relations )Order (QDRO).
- On account of certain disasters for which IRS relief has been granted.
- Due to a “separation from service” (i.e., ceased to be employed by the company sponsoring the plan) during or after the calendar year in which the participant reaches age 55.
When you’re considering tapping into your retirement plan, make sure you have researched all ramifications carefully. While it can be a feasible solution for some, it might not make sense for others.
John Evans is a LPL Financial Advisor at MidWestOne Bank. He specializes in investments and retirement planning.
MidWestOne Bank and MidWestOne Investment Services are not registered broker/dealers and are not affiliated with LPL Financial.
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