Hit Hard by Hurricane? Tapping Your 401(k) May Not Be a Great Idea
The IRS recently relaxed some rules related to hardship distributions from retirement accounts to make it easier and faster for hurricane victims to get money. However, hardship distributions come with costly strings attached.
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.
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.
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.
About the Author
Director of Wealth Planning, First Foundation Advisors
Daniel Fan serves as the Director of Wealth Planning for First Foundation Advisors. Mr. Fan is a Certified Financial Planner™ and holds his Juris Doctorate and Master's in taxation from Pepperdine University School of Law and Golden Gate University respectively. He earned his Bachelor's degree from the University of California, Los Angeles.