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The Hard Truth About Hardship Withdrawals

Workers are putting a crimp in retirement savings by dipping into 401(k) plans early.

More workers are raiding their retirement nest eggs as high unemployment and a sluggish economy continue to take a toll on the financial health of Americans. A recent Fidelity survey found a sharp rise in hardship withdrawals from 401(k) plans. The top reasons cited for the withdrawals were to prevent foreclosure, pay for college and purchase a home.

A hardship withdrawal should be considered a last resort, assuming the option is available at all. Not all 401(k), 403(b) and 457 retirement plans permit hardship withdrawals. Those that do require evidence of an immediate and heavy financial need, such as a medical emergency or imminent eviction.

The Hard Truth About Hardship Withdrawals

— — Tetra/Getty Images

A hardship withdrawal isn't a loan. You can't repay it, and you lose the tax and retirement-income advantages of the money. You'll have to pay income taxes on the withdrawal. In most circumstances, if you're under 59 1/2, you'll also pay a 10 percent early withdrawal penalty.

Consider this: Someone over the age of 59 1/2 who's in the 25 percent federal income tax bracket would have to withdraw more than $13,000 to have $10,000 left over after taxes have been paid. Someone under 59 1/2 would have to withdraw more than $15,000 to net $10,000 after taxes and penalties.

That's a hefty price to pay. Before you even contemplate a hardship withdrawal from your 401(k), look at other ways to drum up cash. Some options might not seem better on the surface, but once the tax bite is factored in, not to mention the long-term impact of tapping retirement savings prematurely, one of those alternatives could turn out to be preferable.
Borrow from your retirement plan at work. Most workplace retirement plans allow employees to borrow from their accounts. This can be far preferable to a hardship withdrawal, since the loan can be repaid into your retirement account over time. Just keep in mind that the loan will come due if you leave your job.

Make Roth IRA withdrawals. If you have a Roth IRA, you can withdraw your contributions (but not any earnings on your contributions) without having to pay taxes or penalties. That trumps the 10 percent penalty on an early withdrawal from a 401(k).

Take a temporary loan from a traditional IRA. If you feel like your financial problems are temporary, you can borrow from your traditional IRA accounts. So long as you redeposit the money within 60 days, no taxes or penalties are due. If you can't repay all of it, you'll incur taxes and, perhaps, penalties, but even so you'll be no worse off than if you'd taken a hardship withdrawal from your workplace plan.

Tap into your life insurance cash value. If you have whole life insurance or similar policies that build up cash values, you can borrow up to the full cash value in the policy.

Sell nonretirement investments. You can also get your hands on money by selling some investments such as stocks or certificates of deposit. Just make sure you sell assets that are held in nonretirement accounts.

Get tuition payment help. If you have a child in college and have suffered financial reversals, contact the college about reapplying for financial aid or receiving other financial assistance. Financial aid officers may be willing to take significant changes in your circumstances into account.

Work part time. Moonlighting if you already have a job or working part time if you're between jobs will help augment income. In a bad economy, employers tend to be more willing to hire part-time, short-term and temporary workers.

If you've exhausted your options and feel you have no choice but to take a hardship withdrawal, contact the plan administrator in the personnel department of your company. That person can help you find out the required procedures.

As you calculate how much money to withdraw, try not to take more than you absolutely need. An amount that may seem insignificant today can mean a lot over time. The tax and retirement effects are just too onerous.

But today's economic realities may necessitate a hardship withdrawal to remain in your home, feed your family or tide you over until you start a new job. It's those situations for which hardship withdrawals are intended.

All the information presented on is for educational and resource purposes only. We suggest that you consult with your financial or tax adviser regarding your individual situation. Use of the information contained in this website is at the sole choice and risk of the reader.

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