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Retirement Planning: Explaining 401(k) Rules for Withdrawal February 2, 2009

Posted by retirementwithaplan in retirement, Uncategorized.
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These are tough times and folks are eyeballing their 401(k)s a possible source of cash. You should think twice, perhaps even a third or fourth time. 020209mis_post_crtnLet’s first discuss the ways your 401(k) can avoid being taxed upon withdrawal (yes withdrawal triggers a taxable event) and the 10% penalty for taking funds out before 59 1/2.

You die. This is not the option I would suggest but it does bring up an important point about beneficiaries. Be sure to name one and in some cases you can simply reference whomever your will designates. You do have a will, right? Ask your lawyer for the best legal phrase to use in your state designating beneficiaries other than your spouse.

Disability can exempt you from the taxes owed but that is, once again, a hardship that no one wants.

Older employees who have lost their jobs are eligible to withdraw their 401(k)s if they are least 55 year old. As this practice may seem the best strategy, it should also be the last. Losing your job at that age can have the greatest effect on your plan’s goals. Before touching that retirement plan, exhaust every other possible option.

Once those funds are taken out, annual contribution limits make replacing them nearly impossible. The lost investment potential is another reason to explore what you can adjust in your budget. Add to that the effort you need to show the IRS proving your hardship, the restrictions on contributions to your plan (no contributions for six months after distribution), and you have, as I suggested, explored all other financial assets for potential emergency cash.

But sometimes those needs might find you requiring less than is allowable as a medical expense deduction (currently 7.5% of your adjusted gross income). It is good idea to get with your tax person to confirm this exception.

And lastly, a qualified domestic relations order for the sale of part or all of your plan’s holdings is allowable and triggers the exception rule.

Those penalties are trigger in the following circumstances (10% plus income taxes but the IRS considers them viable hardships.

  • Repairs of primary residences – try to use the money for saleable repairs.
  • Funeral expenses – one of the hardest costs to estimate; consider every alternative prior to suing the cash for this expense.
  • Payments necessary to prevent you from being forced out of your home – once again, explore refinancing options and credit counseling (avoid debt management services) first or deal directly with your lender.
  • Home foreclosures – these events have triggered tax problems that most folks had not anticipated. Removing money from one account to help pay for another doesn’t lessen the obligation, simply shifts it.
  • Payments of college tuition & other educational costs such as room & board, transportation, food, etc. – you new hardship may make your offspring better eligible for loans of their own, obligations you can help them with once you regain your footing.
  • Purchase of principal residence – there is a longer payback period for this type of withdrawal but wouldn’t you have been better off saving for the down payment in a Roth IRA held outside of your tax-deferred accounts?
  • Unexpected or un-reimbursed medical expenses – these can catch the best of us unawares and perhaps our new President will offer his own brand of tax relief to this unfortunate and discriminatory part of the tax code and the health system.

A better option is the 401(k) loan – better, not best. It comes with the numerous restrictions (borrow the lesser of $50,000 or one-half of your retirement plan balance) and payback must begin immediately. Those restrictions also include a five year payback window (60 days if you lose your job and it will then be subject to all of the penalties of withdrawal if this brief payback time proves to be impossible to do), payments made with after-tax dollars (think of it this way: you pay back the loan with after-tax dollars and when you withdraw the money again at retirement, you are taxed again) including interest (usually competitive with current rates) and of course the ever-present loss of potential growth with the money that was once inside the account now outside the account.

While your credit score in inconsequential since you are loaning the money to yourself and the application fees are minimal, does not lessen the numerous risks. The best advice bears repeating: exhaust every other option first before looking to this precious (albeit in many cases, tarnished) jewel of your future. It may not be the best of all worlds as it once was billed, but it is what you have and it deserves careful consideration, careful tending and thoughtful care.

Next up: Your 401(k) and a Job Change

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Comments»

1. Retirement Planning: The Job Change and Your Retirement Plan « Retirement with a Plan - February 4, 2009

[…] The first thought is: It is my money, i want it. Your old company will be more than happy to cut you a check and once in hand, the temptation can be almost overwhelming. But there are problems with this approach and you should know what they are. (Find out more about exceptions and rules to 401(k) withdrawals here.) […]

2. Retirement Planning: Engineering the Perfect Retirement Cocktail « Retirement with a Plan - February 5, 2009

[…] until you reach that age marker. If you find yourself without a job at age 55, you can begin to tap those plans as […]


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