More Folks Raiding 401(k) Accounts

(MoneyWatch)  A record number of workers took money out of their retirement accounts, according to a report issued by Fidelity Investments.

During the second quarter, a record 62,000 of some 11 million participants with 401(k) accounts administered by Fidelity made a special type of withdrawal - called a hardship withdrawal - which was up from 45,000 during the first quarter.

The most common reason given for taking these withdrawals was that the money was needed to hold off a foreclosure or eviction, to pay college tuition, or to buy a home.

Hardship withdrawals are different from loans. These special withdrawals are taxable, including a ten percent penalty for early withdrawal. Hardship withdrawals, which are widely available in many 401(k) plans, allow individuals in certain situations to take money from their 401(k) plan accounts while they are still working for the employer that sponsors the plan.

Hardship withdrawals may be taken only if there is an immediate and heavy financial need and the withdrawal is necessary to satisfy the need (i.e. the money needed cannot be obtained from any other reasonable source). According to IRS rules for hardship withdrawals, these are only permitted for specific reasons, which include medical expenses that exceed 7.5% of adjusted gross income, purchase of a primary residence, payment of qualified tuition expenses, funeral or burial expenses, home repair expenses due to casualty losses, and to prevent eviction or foreclosure of a mortgage on a primary residence.

There are several downsides of taking hardship withdrawals from a 401(k) plan. The amounts distributed are taxed as ordinary income and if the individual is under age 59½, an additional ten percent penalty will apply to the amount withdrawn. Also, 401(k) plans generally must bar employees from making 401(k) contributions for six months after taking a hardship withdrawal. Amounts taken as a hardship withdrawal cannot be repaid to your 401(k) account so they permanently reduce your retirement plan account balance. Another downside: many employers require you to provide a written explanation of the reason for requesting a hardship withdrawal and why the need cannot be satisfied from other reasonable resources. The revealing of private details can feel invasive and awkward.

Check in later this week when I'll provide several alternatives that may be the better option for folks considering hardship withdrawals.