Retirement Plan Hardship Withdrawals

One of the worst financial decisions a baby boomer can make is to raid a tax-deferred retirement account such as an IRA or 401(k) to pay for non-retirement expenses. I like to call these early withdrawals “retirement plan leaks” although sometimes they are more like floods!

401(k) Plan Hardship Withdrawals

How do these retirement plan leaks occur? The most common scenario is a hardship withdrawal. These early withdrawals are permitted in some circumstances, such as to cover un-reimbursed medical expenses, to purchase a principal residence,  to pay certain education expenses, for payments necessary to prevent eviction or foreclosure, funeral expenses, and certain expenses for the repair of damage to your principal residence.

An “early withdrawal” is one that occurs before the plan participant reaches age 59 and 1/2.

However, a hardship withdrawal from a 401(k) account can still trigger a 10% penalty plus taxes owed, unless you are:

• Totally disabled
• Your unpaid medical expenses exceed 7.5 percent of your adjusted gross income.
• You are required by court order to give the money to a divorced spouse, a child, or a dependent.
• You leave your job due to layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.

According to a recent GAO Report, an early withdrawal or complete retirement plan cash-out of this nature at job separation is terribly damaging to your retirement future:

Participants who voluntarily cashed out their entire 401(k) account balance at job separation experienced the largest reductions in the amount of retirement savings that accumulate over their working careers,” the report noted.

For example, a participant who cashed out his entire 401(k) at age 35 would forfeit more than $183,000 in savings by his 65th birthday, according to the report. Cashing out later in a career, when there is less time to recover from losses, leaves an even bigger wealth gap.

I couldn’t have said it better myself.

One aspect of a 401(k) hardship withdrawal that many folks don’t consider is that the person making the withdrawal is prohibited from making more contributions to his or her 401k account for six months after the withdrawal. This prohibition also includes employer contributions.

I think that anyone over the age of 50 who proposes to cash out or take a hardship withdrawal from a retirement account should receive mandatory counseling from a financial advisor.

IRA Hardship Withdrawals

The rules for hardship withdrawals from an IRA are somewhat different. Also, traditional and Roth IRAs have different rules.

An IRA owner can make no-penalty hardship withdrawals for:

• Excessive un-reimbursed medical expenses.
• Payment of medical insurance premiums while unemployed.
• Total and permanent disability.
• Distribution of account assets to a beneficiary after you die.
• Certain qualified educational expenses.
• First time home purchases (maximum of $10,000 per purchaser)

If this is a conventional IRA, you still must pay taxes on the withdrawals.

Finally, the IRS will allow early withdrawals from an IRA without penalty based on the “substantially equal periodic payment rule.” Using this method, you must distribute the entire IRA balance using equal payments spread over your life expectancy.

The bottom line is that baby boomers should consider an early hardship withdrawal from a retirement account only as an absolute last resort.

Photo credit: The Pageman

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