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 Since the Great Recession, loans from 401(k) accounts have been
rising. Some 17.6 percent of plan participants had loans outstanding
last year, compared with 15.3 percent in 2008, according to the
Investment Company Institute (ICI). A much smaller number of 401(k)
participants (1.3 percent) took hardship withdrawals last year,
according to the ICI.
The loan numbers reflect the financial pressures facing so many
households. A recent survey by the Pew Charitable Trust found that
60 percent of U.S. households experienced a financial shock in the
past 12 months. This was typically lost income due to unemployment,
illness, injury, death or a major home or vehicle repair.
When trouble strikes, backup emergency cushions are often glaringly
absent. Lower-income households (income below $25,000) had enough
savings to replace only six days of household income. Even
households with more than $85,000 say they can replace just 40 days
of income from savings, Pew found (http://reut.rs/1qR2Zwe).
Plan sponsors are not required to allow loans or hardship
withdrawals, but about 90 percent do, said Lynn Pettus, national
director of the employee financial services practice at Ernst &
Young LLP. “Most of them think flexibility is necessary because at
the end of the day employee is putting away their own money for
retirement,” she said.
But employers and retirement policy experts worry about early
withdrawals.
This kind of account leakage is one of the culprits behind the
anemic retirement savings that so many workers must eventually
confront. In addition, pre-retirement withdrawals come with plenty
of downside and risk, ranging from lost investment returns to taxes
and penalties.
Retirement accounts are not a convenient way to obtain cash in an
emergency, because it can take time to access your funds. “As soon
as administratively possible is the norm” said Pettus. “That said,
we have seen 10 business days, 15 business - even 90 days.”
LOANS
Your workplace plan can allow you to borrow up to half of your plan
balance, up to a maximum of $50,000. There is no 10 percent early
withdrawal penalty, since you are borrowing, not withdrawing, funds.
There is no credit check, and you can repay the loan through payroll
deductions. Interest rates typically are modest, often around 5
percent, and bear in mind that you are paying interest to yourself.
A big downside: Foregone investment returns on the borrowed funds
are gone forever. Moreover, your repayments of principal and
interest on the loan typically come from after-tax dollars. When you
withdraw that money later on in retirement, the interest effectively
is subject to taxation a second time (that does not apply to the
principal, since when you take the loan it is not a taxable
distribution).
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Also ask yourself if you are sure you can repay the loan, which
typically must be repaid within five years. Should you default, the
outstanding balance will be subject to the 10 percent early
withdrawal penalty and any regular income taxes owed. On a $20,000
balance, you are facing a $2,000 fine and another $3,000 in income
taxes (assuming a 15 percent tax bracket). That can really hurt if
you already are experiencing financial stress.
HARDSHIP WITHDRAWALS
Retirement plans are not required to offer hardship withdrawals, but
if they do, the need must be based on a demonstrated “immediate and
heavy financial need,” according to Internal Revenue Service (IRS)
rules. The withdrawal must be used to satisfy that specific
financial need, and cannot exceed the amount of the demonstrated
need. There is no guarantee the withdrawal will be approved.
Examples of qualifying needs include certain medical expenses, costs
related to buying a home, college tuition, payments to avoid an
eviction or foreclosure, burial expenses and home repairs.
This really is a last-resort measure, because the downsides are big.
You have permanently reduced the size of your retirement account,
and foregone future tax-deferred growth on those dollars. The plan
sponsor can prohibit additional contributions for six months after
the withdrawal, along with any matching contributions.
You will owe income taxes on any amount withdrawn, along with the 10
percent federal penalty if you are under age 59-1/2. Withdrawals are
exempt from the penalty under certain circumstances. The IRS
publishes a chart detailing withdrawals that may be exempt from the
penalty (http://1.usa.gov/1VQOtST).
So which option is better - a loan or a hardship withdrawal - in
case stuff happens? A loan, said Pettus. “It’s always better,
because you pay yourself back.”
(The opinions expressed here are those of the author, a columnist
for Reuters)
(Editing by Matthew Lewis)
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