Raising Cash in Tough Times

The ongoing housing and mortgage market mess, struggling stock market and uncertain economic climate means tough times for cash-strapped individuals who have to raise money for an immediate financial need. Compounding the misery is the fact that many people have locked away the lion's share of their savings in a tax-favored retirement vehicle, like a company profit-sharing or 401(k) plan, IRA, SEP, SIMPLE IRA, or Roth IRA. Getting to that money to solve a pressing financial crisis before age 59-1/2 isn't easy and can be financially painful.

Generally, tapping into a profit-sharing plan, IRA, SEP, or SIMPLE IRA requires a taxpayer to pay the tax on the amount withdrawn and, unless a taxpayer meets one of the limited exceptions, a 10% early withdrawal penalty. To make matters worse, where the taxpayer lives in a state with an income tax, and possibly a state early withdrawal penalty, the overall amount of the withdrawal that goes to taxes and penalties can approach 50% of the amount withdrawn. (Note: Roth IRAs and some Traditional IRAs include certain amounts that can be withdrawn without tax and penalty).

In general, there are only two ways for active employees who are under age 59-1/2 to tap their account balances in 401(k) plans: take a loan from the plan or take a hardship withdrawal, if they are eligible to do so. But just because the plan may permit a withdrawal for hardship, it does not mean that the withdrawal will avoid either being taxed or subject to the early withdrawal penalty.

401(k) Loans – When money is borrowed, there is no taxable event since it is merely a loan. However, loans must be paid back, and if a taxpayer subsequently defaults on a 401(k) loan, the loan becomes a taxable distribution subject to tax and penalties. An often-overlooked hazard to a 401(k) loan is the possibility of leaving employment with the plan’s sponsoring employer, at which time the loan would have to be paid in full or it would become a taxable distribution subject to the usual penalties.

Hardship Distributions – The law limits when distributions to participants of 401(k) and similar plans may be made – usually when the employee separates from service (retires, changes jobs), dies, becomes disabled or reaches age 59-1/2. For some plans, a hardship distribution may be permitted. A distribution is treated as made after an employee's hardship only if it is made on account of the hardship which, in turn, requires that the distribution be:

• Made on account of an immediate and heavy financial need of the employee; and
• Necessary to satisfy that financial need.

What is an immediate and heavy financial need? Under IRS safe harbor rules, a distribution is treated as made on account of an immediate and heavy financial need if made for:

(1) Expenses for (or necessary to obtain) deductible medical care (which includes expenses for the care of a spouse or dependent);

(2) Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);

(3) Payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, or the employee's spouse, children, or dependents;

(4) Payments necessary to prevent the employee's eviction from his principal residence, or foreclosure on the mortgage on that residence;

(5) Payments for burial or funeral expenses for the employee's deceased parent, spouse, children or dependents; or

(6) Expenses for the repair of damage to the employee's principal residence that would qualify for the casualty deduction.

Maximum distributable amount – A hardship distribution can't exceed the maximum distributable amount which includes the employee's total elective contributions on the distribution date, reduced by any previous distributions of elective contributions. It also may include employer contributions depending on how those contributions are made (i.e., matching or non-elective), and how the plan is organized. Not all plans are the same so the employer will need to be consulted.

Obtaining a hardship distribution from a 401(k) plan isn't easy, and shouldn't be used as a way to raise needed cash if other sources are available. The plan participant should keep in mind that:

• The taxpayer’s definition of hardship may not fit within the plan's definition.

• If the plan uses the safe harbor method of treating a distribution as necessary to meet an immediate and heavy financial need, he will be barred from making elective contributions (and will therefore forfeit any employer-matching contributions) for a period of at least six months.

• The taxpayer may have to take a loan first from the 401(k) plan before he can take a hardship distribution.

• Depending on how the plan is organized, the taxpayer may not be able to withdraw his entire balance.

• The taxpayer will forever lose the tax-deferred earnings buildup that would have accrued on the hardship withdrawal had it not been made.

• The taxpayer will have to pay tax at ordinary income rates on the withdrawal (assuming no after-tax contributions were made) and, probably, a 10% premature withdrawal tax as well.

Before tapping into your retirement funds, we encourage you to call this office so we can help minimize the damages and avoid penalties wherever possible. Using funds meant for your retirement can have long-term consequences that should be considered carefully.

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