Facing Tough Times? Know that Raiding Your Retirement Is Extremely Risky

The past year has been extremely tough on both investments and living costs for many people. But no matter how tough circumstances get, it’s critically important to try and keep one’s hands off their retirement funds.

Recently the Transamerica Center for Retirement Studies reported an increase in workers taking loans from their 401(k) and other work-based retirement savings. Eighteen percent of those surveyed reported they took loans from their retirement plans in 2007 compared to 11 percent in 2006. Yet keep in mind that while most plans provide an option for hardship withdrawal for emergency medical or funeral expenses, the IRS restricts use of those funds for home purchases or tuition expenses.

There are serious financial consequences to breaking into 401(k) and other tax-advantaged retirement savings, and individuals tempted to do so should look for other alternatives.

Options are limited. There are such things as hardship loans, but the circumstances under which you can do so are limited. You can only use the money if you need to pay down medical expenses, avoid foreclosure on your primary home, pay college tuition, lose your job, become disabled or need to cover funeral expenses.

You’ll generally pay penalties. You’ll likely have to pay a 10 percent penalty if you take a distribution on retirement assets at 59.5 years of age or less. If you take a distribution from your employer-sponsored plan, the employer is required to withhold 20 percent in tax penalties. In addition to those percentages, you’ll also pay income taxes on the money you withdraw, which could mean that withdrawal may cost you anywhere from 30-40 percent that will go back to the government.

Even if you don’t pay penalties, there are still risks. In the case of IRA withdrawals that you might take for your child or grandchild’s education (as well as your own or your spouse’s), these can be taken out without the usual 10 percent penalty on early distributions before age 59 ½. But you really need to talk with a tax advisor or a personal finance expert like a financial planning professional to determine whether your IRA withdrawals will have to be reported on your Form 1040 and whether any tax headaches might ensue.

Be careful with loans. Generally, you have five years to pay back a loan on your 401(k) plan without having to pay a penalty or taxes. For a first home, you may be able to take as much as 15 years to pay it back, but the amounts can be limited. In most cases you can only withdraw up to 50 percent of the value of your 401(k) up to $50,000. But what happens if you’re fired or you quit? You’ll have to pay back the entire amount that you borrowed within two or three months. If you can’t do it, you’ll owe taxes and a 10 percent penalty on what you took out.

Be extra careful with 401(k) debit cards. In the last year, companies have been offered the chance to link their employees to their money through a debit card. This was a very bad idea. Each transaction is a loan that must be paid back to the 401(k) account. If you default on the loan, you’ll still face taxes and penalties. Read those rules very carefully, and better yet, just cut up the card.

Watch out for fees. Keep in mind that beyond the amount of investment gain you’ll lose while that money is out of the account, you might be charged a heavy fee by the company that’s sponsoring the 401(k) or the investment firm that’s handling the IRA.

Be aware of outside consequences. You might hurt your kid’s chances for financial aid in college. The entire withdrawal from an IRA—whether taxable or not—must be included as income on the following year's application for the Free Application for Federal Student Aid, or FAFSA. Family income does more to influence financial aid than the size of the family’s assets, and dipping into your IRA can potentially damage your child’s potential financial aid. Check with a trained financial planner expert in financial aid strategy before you make a move.

Source: Financial Planning Association