||Ask Dr. Don
401(k) hardship withdrawals
Hello Dr. Don,
I'm a 38-year-old fellow, married to
a wonderful woman for 18 years, with four daughters. For years,
I've been trying to get myself out of debt, but something always
seems to come up. Items such as tuition for grammar school, braces,
home repairs, automobile needs, etc. always arise.
My first mortgage was refinanced to pay off credit
cards and signature loans. We've taken out a second mortgage a few
times, which was used to pay off additional required loans. I've
also borrowed from my 401(k) plan.
I estimate that 87 percent of my net salary is used
for some form of contractual payments. Meanwhile, I can't contribute
to my 401(k), save any money, nor make more than the minimum payment
on my credit cards.
One hopeful thought is if my 401(k) loans would go
away. I could redirect this money to pay off my credit card balances,
then attack my second mortgage, then resume (after my 401(k) suspension
period) contributing to my retirement plan. The only statement in
my 401(k) plan to tickle a hopeful thought is the hardship withdrawal.
Is there any way I can convince our 401(k) plan provider
to allow me not to repay the money I had borrowed from my retirement
fund? Unless something can be done, I'll never be able to build
up my 401(k) or get a handle on my debts. The 401(k) loans will
be paid off in two and a half, four and a half and five years, respectively.
Most 401(k) plans have a provision for hardship withdrawals.
Plan participants typically qualify if they can show a financial
need that is both immediate and heavy, and that the withdrawal is
needed to meet the need. Citing the need to withdraw money because
you need to stop the payments on the 401(k) loans will be a tough
row to hoe.
The IRS has two standards for determining whether
the need is immediate and heavy: facts and circumstances or safe
harbor. Your plan will choose one of those two standards and evaluate
requests for a hardship withdrawal based on that standard.
The safe-harbor standard is more commonly used because
it's easier for the plan to document and manage. It's also the harder
standard of the two to qualify for. You'd have a better case with
showing the plan provider the facts and circumstances that led you
to request the withdrawal.
Safe-harbor hardship withdrawals are limited to:
1. Payment of certain unreimbursed medical expenses.
2. Purchase of a primary residence.
3. Payment of post-secondary education expenses for the next year.
4. Payments necessary to prevent eviction from or foreclosure
on your primary residence.
Plans usually make you exhaust your ability to borrow
from your 401(k) before you can qualify for a hardship withdrawal.
Talk with your plan provider about whether you would be able to
qualify for a hardship withdrawal.
The thing to remember is that a hardship withdrawal
doesn't mean that income taxes and a 10-percent penalty tax aren't
due. It just means you can withdraw the money from the 401(k) plan.
I don't know your marginal federal tax rate, but assuming
a 31-percent rate, 41 percent of the money you withdraw could wind
up paying taxes on the distribution. Mandatory withholding was dropped
to 10 percent from 20 percent in last year's tax bill, but that
just affects the size of the check, not your tax bill for the distribution.
You obviously can't withdraw what you've already borrowed,
so having those loans reclassified as distributions will make them
subject to income taxes and the 10-percent penalty tax. The payments
would go away, but triggering this tax event adds to your money
You've run out of wells to tap in managing your family's
finances. You haven't been able to build wealth because your expenses
exceeded your income. Cashing in your retirement money to pay down
these bills isn't a realistic answer to your problems.
If you owe 41 cents on the dollar for the money you've
already borrowed and 41 cents on the dollar for the money you need
to borrow, then its going to be difficult to raise much cash through
a hardship withdrawal.
Hire a financial planner to help you structure a budget.
Look for a second job to help pay down some bills. You didn't get
into this situation overnight and you won't get out of it overnight,
but you can make substantial progress by managing your spending
and adding a new source of income.
If that doesn't work, it's time to consider
a consumer credit counseling agency. Check out this Bankrate
story for assistance in selecting one. Good luck to you.
-- Posted: May 2, 2002