Raiding Your 401K? It’ll Cost You

Tom Jeffries | April 26th, 2011

A recent study by Bankrate found that nearly one-fifth of full-time employed Americans have raided their retirement accounts in the past year to cover emergency expenses. These results match a Fidelity Investments study last year that reported the number of workers borrowing against their retirement accounts had reached a 10-year high. Given the financial stress that many workers face today, the numbers are not that surprising, but the long-term consequences can be.

Workers who tap their retirement funds prematurely face penalties both in the short term and in the long term. The withdrawn funds are subject to taxes, and if the worker is younger than 59 ½, he or she will pay a 10 percent penalty for early withdrawal. For example, a worker who withdraws $10,000 could receive $6,500 after early withdrawal penalties and taxes, if he or she is in the 25 percent tax bracket.

However, the larger financial price for the participant occurs over the longer term. After a “hardship” withdrawal is taken, salary deferrals must be suspended for six months. So not only does the participant forgo the ability to save for six months, he or she also misses out on any employer match that would normally be offered during the period. As time goes on, the participant faces the loss of compound earnings that would have been earned on the money if it had not been withdrawn. This means the employee will not only need to replenish the funds once he or she regains financial stability, but may need to add even more money to the account to make up for the compound interest they lost – if the worker wishes to reach his or her original retirement goal.

To receive a hardship withdrawal, participants must demonstrate an immediate and heavy financial need, as defined by IRS regulations. These needs include certain medical expenses, costs toward the purchase of a primary home, tuition or education expenses, payment to prevent foreclosure or eviction, burial or funeral expenses or repair of damage to a primary home.

Hardship withdrawals are not required in retirement plans, and some employers don’t provide them as an option to avoid abuse of withdrawals by plan participants. If you would like to discuss hardship withdrawals and your retirement plan, please contact your financial advisor.

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