When facing the choice of whether to take money from your retirement fund before you retire, make sure you know the penalties and consequences for your taxes and financial plan.
After committing to building your retirement savings, the last thing you want to do is have to deplete them to meet a different expense. However, there may come a time when your best or only financial option is to turn to your retirement plan for a loan or a hardship withdrawal. By doing this, you diminish your retirement funds, but it may allow you to reduce your debt or pay for an urgent expense, such as a medical or educational bill. Learn when you are able to borrow or withdraw money from your retirement plan and the implications for your taxes and financial plan if you do so.
Just as with any other type of loan, a loan from your retirement plan is an amount you borrow and then pay back with interest. Both the amount you borrow and the interest will go back into your retirement account upon repayment, and these types of loans are often repaid directly out of your paycheck. Since you are planning to pay back the loan, unlike a straight withdrawal, you know that your retirement account will eventually be restored by the amount you borrow, and this promissory payment has a guaranteed rate of return. However, keep in mind that, while making loan payments, you may not be able to make contributions to your retirement account at the same level you were prior to taking out your loan.
Plan eligibility for loans
According to the IRS, you may take loans from “qualified plans,” including 401(k)s, certain types of annuity plans, including 403(b)s and also from governmental retirement plans. Although these types of plans may offer you the option to take out a loan, they aren’t required to. To see if your plan gives you this option, check the plan documents you received when you enrolled or check with your plan administrator. You cannot take a loan from an IRA; if you do so, the IRA will no longer qualify as an IRA, and it will become part of your taxable income.
Unlike a withdrawal, you do not need to prove financial hardship to take out a loan from your retirement plan. These types of loans generally don’t require a lot of paperwork, although you will have to sign a repayment agreement specifying the number, amount and due dates of loan payments. The specific terms of this agreement will be set up by your plan sponsor and/or employer. However, there are some restrictions on these types of loans. You may only borrow the lesser of (1) $10,000 or 50 percent of your vested balance of the account, whichever is greater or (2) $50,000. These restrictions apply to the total of all your outstanding loan balances per retirement account. In addition, loans from your retirement plan must be paid back within five years, or within 10 years for loans related to buying a home, and these payments are generally required on at least a quarterly basis. Finally, when borrowing from an employer-based plan, the loan’s terms are contingent on your continued employment with that employer. If you lose or change your job, you will have to pay the outstanding balance within 60 days or face the penalties that come with failing to repay.
As long as you repay the loan within the agreed-upon timeline, the amount you borrow is not considered taxable income. However, if you fail to repay the loan, the unpaid amount will be considered taxable income for the year you failed to repay it. In addition, this amount will be subject to a 10 percent early withdrawal tax, unless the reason you borrowed the money qualifies as an exception to this tax.
Keep in mind that the interest you pay on the loan will be taxed twice. The money paid into the retirement plan was done so pre-tax (and your loan is not taxed), but the extra money you’ll pay in interest has already been taxed once, whenever you received it. This money will go into the retirement account and then be taxed again once withdrawn.
Other considerations when borrowing money from your retirement plan
There are some inherent downsides to borrowing from your retirement plan. When you borrow money from your retirement account, you lose some of the value of compound savings in your account, as you are giving yourself less principal to build on. You may also find it hard to repay your loan and build up your retirement savings at the same time, so your overall contribution may go down. Borrowing money may also cause you to lose diversity within your retirement portfolio by reducing the amount of overall assets.
If you find yourself in a position where you need a loan to pay for a necessity, you should first compare loan options from other financial institutions, and then make your decision based on what makes the most financial sense. And, if you decide to borrow from your retirement account, you should try to continue to make contributions to your account while paying off your loan, if you are able to do so.
Unlike a loan, a hardship distribution is when you remove a part of your retirement savings without the intent to pay it back. The amount you withdraw will permanently reduce your retirement account balance, and you may be required to prove that this withdrawal is for a financial need and that you have no other way to pay for it. The qualifications for hardship distributions are stricter and the penalties harsher than for loans taken from a retirement account.
Plan eligibility for hardship distributions
Certain retirement plans may, but are not required to, allow participants to receive hardship distributions. 401(k), 403(b) and 457(b) plans may provide for these types of distributions, and the IRS gives specific guidance for these three types of plans. To see if your plan gives you this option, check the plan documents you received when you enrolled or check with your plan administrator. Each plan will also specify the documentation required to prove your financial hardship; generally, this documentation will require you to describe the hardship you are undergoing and verify that you don’t have other resources to pay for it.
Hardship distribution restrictions
The restrictions for 401(k) and 403(b) plans are similar, while the restrictions for 457(b) plans follow different rules.
For 401(k) and 403(b) plans, hardship distributions must be made on account of an immediate and financial need, and the amount must be limited to the amount necessary to satisfy the need, according to the IRS. Either your employer can determine this need using your documentation of the hardship, or you will be automatically considered to have an “immediate and heavy” need if the money is used for:
· Certain medical expenses
· Costs relating to buying a principal residence
· Tuition/educational fees/expenses
· Payments to prevent eviction or foreclosure on your principal residence
· Burial/funeral expenses
· Certain expenses for repair of damage to your principal residence
These needs may also extend to your spouse or dependent, should he or she need the funds. To prove that the amount is limited to the amount necessary to satisfy the need, you must take only the money you absolutely need, and you must also be able to prove that you are unable to reasonably obtain the funds from another source, including insurance, liquidation of assets or even loans.
A distribution is also automatically determined as necessary if it only covers the amount needed, you have obtained all other distributions and loans available from the employer’s plans and you aren’t allowed to make elective contributions to the plan for at least six months after taking the hardship distribution. For 401(k) and 403(b) plans, taking a hardship distribution will generally bar you from making elective and employee contributions to all plans maintained by your employer for at least six months.
The amount you take for a hardship distribution is limited to the total amount of elective contributions you have made to the retirement plan as of the date of distribution, not including the amount of any previous distributions of elective contributions. Notice that this amount does not include employer elective contributions or earnings on elective contributions.
For 457(b) plans, you may only take a hardship distribution if you are faced with what the IRS calls an “unforeseeable emergency.” Examples of this would include a severe illness, accident or loss of property due to a casualty such as a fire or tornado. However, expenses that you may not be able to afford but you could have predicted, such as the cost of buying a home or paying for tuition, do not qualify for hardship distributions under 457(b) plans. In addition, if you can pay for the cost of the emergency using insurance, asset liquidation or another method, these circumstances do not qualify you for a hardship distribution.
Unlike loans from a retirement plan, in which you are only borrowing the money, hardship distributions are included in your taxable income for the year you received the distribution, unless the distributions are from designated Roth contributions. You will also usually have to pay a 10 percent early withdrawal tax on the distribution, unless you are using the money for something that is considered an exception to this rule. When considering the amount to withdraw, you should consider the taxes you will owe on the distribution—the IRS includes taxes you might owe on the distribution in its restriction that specifies the amount you take must be “limited to the amount necessary to satisfy the need.”
When considering withdrawing or even borrowing money from your retirement account, these options should always be viewed as a last resort. Depleting your retirement savings can be dangerous, especially if you find that you can’t repay your loan or you will owe a large amount in taxes on early withdrawals. Before deciding to dip in to your retirement savings, consult with your financial advisor at Safe harbor Fiduciary to see if you have any other options for emergency funds.
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