The recent hurricanes in Texas, Florida and Puerto Rico have been devastating. Recovering from the storm damage is a daunting, and potentially very expensive, task. Those without robust emergency savings accounts are facing some tough decisions about where to find the resources to pick up the pieces. One place people may be looking at is their retirement plan, but that could be a big mistake.
The IRS has announced the removal of restrictive rules and procedures for withdrawals from employer-sponsored retirement plans (e.g., 401(k) and 403(b) plans) for hurricane victims. The removal of these hurdles will make it easier for these individuals, and their relatives who can take distributions from their own plans, to withdraw funds to pay for damages and related expenses. But that doesn’t mean you should do it.
The relief provided only relaxes the procedural and administrative rules related to withdrawals. It does not provide any tax relief. The IRS has stated that these withdrawals will still be subject to income tax and, if applicable, penalties. Even with the ability to access these funds, retirement plan participants affected by the hurricanes should strongly consider exhausting other funds first, and should use hardship withdrawals from retirement plans as an absolute last resort.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Qualifying for Hardship Distributions
The special rules the IRS announced are designed to help people who need emergency funds get them faster than they normally would.
The rules for obtaining hardship withdrawals, in general, can be substantial. Normally, the only way for an employee to obtain a withdrawal from an employer-sponsored retirement plan is for it to qualify as a hardship withdrawal or to take a loan, except for unique cases.
Although hardship withdrawals and loans are permitted by the IRS, plans are not required to provide them. Someone who wants to take a hardship withdrawal would need to check with a benefit or plan administrator to see if the plan allows for it. Many plans do not.
Even if hardship withdrawals are permitted, they are allowed only for an “immediate and heavy financial need” and are limited to the amount necessary for that need. Not all expenses qualify. For example, funds to provide for temporary housing and food will likely not qualify, while money needed to repair damage to the employee’s home will. The IRS also requires that the plan sponsor retain thorough documentation.
Downsides of Hardship Distributions
What’s more, hardship distributions are subject to income taxes, unless they consist of Roth or after-tax contributions. Each dollar withdrawn from a retirement plan is generally taxed as ordinary income. Withdrawals may also be subject to a 10% penalty on early distributions, for those under age 59½.
In addition, hardship withdrawals put a permanent dent in your retirement account, because employees who take them cannot later repay them to the plan or roll them over to another plan or an IRA. And those who take a hardship distribution are banned from being able to make additional contributions to the plan for a six-month period. The effect of those restrictions is worsened by the loss of compounding growth for the amount withdrawn.
A Better Choice: Borrowing from Yourself
Hopefully, you have a robust savings account for emergency situations. If not, a better option than obtaining a hardship withdrawal might be to a take loan from the plan. The law allows you to borrow up to $50,000, or half your vested balance, whichever is less. Loans, though, typically need to be repaid (with interest) within five years to your account. And if you lose your job, they need to be repaid immediately, something to really think about if you’re in an industry where layoffs are common.
One big advantage of taking a loan from your retirement account is that when you pay it back, you’re paying yourself back. When you’re done, your retirement account is made whole again, and the growth you’ll see from compounding will be magnified because of it.
Conclusion
Although the IRS has provided special rules that make it easier for hurricane victims to obtain hardship distributions from an employer retirement plan to pay for expenses and repairs, such withdrawals should be made very thoughtfully. This is especially true since the IRS did not provide any tax relief for these types of distributions. If possible, use other sources of funds first, and then take loans from retirement plans.
The damage from the hurricanes has been immense. Don’t allow this disaster to damage your retirement, too.
-
Does My Car Insurance Cover Rental Cars?Is it safe to decline the extra coverage car rental companies offer you when booking? Here's what you need to know.
-
Outsmarting the AI Job Algorithm: Why Older Women Need a StrategyWhen you're job hunting, AI may undermine your best efforts. Here's how older women can throw a wrench in the algorithm.
-
I'm an Investment Adviser: Here's Why You Should Resist a Zero-Down MortgageWhile it's certainly enticing, a zero-down mortgage comes with significant risks, especially if home values decline or you want to refinance.
-
I'm Embarrassed to Ask: What Is a Life Insurance Trust?Life insurance trusts, particularly irrevocable life insurance trusts (ILITs), can minimize estate taxes and protect your heir's inheritance.
-
Are Your Employees Quietly Cracking? How to Repair the Cracks Before Everything BreaksSome employees who are unable to change jobs due to economic conditions are doing only the bare minimum, leading to decreased work quality and team morale.
-
Headed for the Retirement Red Zone? This Eight-Step Game Plan Helps to Avoid FumblesThese strategies help safeguard your nest egg and ensure long-term financial success during the five years before retirement and the five years after.
-
I'm a Financial Planner: This Is How You Can Get Started With RMDsThe IRS will come knocking for its share of your tax-deferred retirement savings when you hit 73, but planning ahead for RMDs will ensure you're ready.
-
How Will You Replace Your Paycheck in Retirement? A Financial Adviser's Tips on Income PlanningBills don't stop once you retire — and you can't expect your Social Security checks to cover them all. Don't risk running out of money. Instead, make a plan.
-
From Pets to Paintings: The Little Things That Can Cause Big Estate TroubleSentimental items might have little monetary value, but their disposition can cause hurt feelings. Talking about who wants what and labeling items can help.
-
The Clock Is Ticking: Take Advantage of These Retirement Tax Benefits While They LastRecent tax changes, including an extra $6,000 deduction for those 65 and older, present a golden opportunity for retirees to reduce their tax bills.
