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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.

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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.

Please advise!

Dear Jeff,
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 problems.

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

Read more Dr. Don columns here
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See Also
8 steps to a healthy 401(k)
Penalty-free early withdrawals
Don't touch that 401(k)!
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