Ilan Cuellar, CFP®, PPC™, CPFA

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Should You Tap Your Retirement Account?

| November 15, 2012

Since the housing and stock markets collapsed several years ago, millions of unemployed and even working 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 their 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 may be required to pay an additional 10% early withdrawal penalty.

Loan Considerations

When considering a loan, there are several rules to keep in mind:

The IRS generally limits the amount of a loan to 50% 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 participants' 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% or 2% 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 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.

For 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% 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% of the participant's adjusted gross income.

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.

To an alternate payee under terms of a qualified domestic relations order (QDRO).

On account of certain disasters for which the IRS relief has been granted.

Note also that a hardship withdrawal cannot be repaid into your account.  Your retirement plan administrator and financial professional can help you determine your options.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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