What Sandy victims can do if they need a loan
Salvatore Conte, 65, looks out at the debris removed from his home that was severely damaged by superstorm Sandy Nov. 5, 2012, in New York. Conte, a Vietnam veteran, has lived in this house since 1995. / AP Photo
(MoneyWatch) Last week I wrote that employers were reporting an increase in workers taking hardship withdrawals from their retirement plans to meet their financial needs in the wake of superstorm Sandy.
Shortly thereafter, the IRS eased requirements for loans and hardship withdrawals for employees and family members who live in the affected areas. To qualify for this relief, the hardship withdrawals must be made before Feb.1, 2013.
But before folks take a hardship withdrawal from their retirement plan, I recommend they consider these alternatives.
401(k) Loans. If your 401(k) plan allows you to take a loan, then it may be worth considering. Unlike hardship withdrawals, amounts borrowed through a 401(k) plan loan are not taxable as income unless the balance goes unpaid. You may also replace the borrowed money by making payments back to your own account. For some people, the problem is that you have to be an employee to be able to take loans from your current employer's 401(k) plan. Loans are generally not available for former employees who have left their 401(k) account in their former employer's plans. And for folks already struggling to climb out of debt, taking out a loan is obviously adds another payment to make.
Regular IRA Withdrawals. People with a 401(k) plan account who are no longer with their former employer typically cannot take a loan from their 401(k) plans. One option is to roll their 401(k) account over to an IRA. That's because under certain situations, they can take withdrawals that are free from the 10 percent tax for early IRA distributions. These special situations where IRA withdrawals avoid the early-withdrawal penalty tax include payment of non-reimbursed medical expenses, first-time purchase of a home, payment of medical insurance premiums, qualified higher education expenses, and disability or death.
While an IRA withdrawal taken on account of one of these special situations will be taxable, it will avoid the 10 percent penalty tax. And in certain situations it may even be advisable to do this. For example, say an individual has an IRA and also needs to pay health insurance premiums in a year they become unemployed. As long as you have received unemployment compensation for at least 12 weeks and the IRA withdrawal is made in the year of or the year following unemployment, then the withdrawal could be exempt from the early-withdrawal penalty. (To properly report penalty-tax free withdrawals from an IRA, you'll need to complete IRS form 5329.)
Roth IRA Withdrawals. Because contributions to a Roth IRA are made with after-tax dollars, people with money in these accounts can take withdrawals of the contributions without paying income taxes and penalties. For this reason, it's a good idea to draw on these accounts before taking money from other retirement accounts where distributions are taxable.
Bankruptcy Protection. For some folks in extreme hardship situations, it may be advisable to seek other forms of financial protection, rather than stripping cash from their retirement plans. The main reason is that under federal law, assets held in an employer's retirement plan or an IRA are excluded from judgments for creditors during bankruptcy. Rather than spending down retirement assets, only to prolong the inevitable bankruptcy, it may be wise to preserve these protected assets and get the bankruptcy process underway sooner. And since many states provide some exemption for your home, after bankruptcy you'll still own the property and your 401(k) or IRA account.
Low-income individuals, including those who suddenly find themselves unemployed, who face sudden and large uninsured medical expenses also may qualify for a certain form of Medicaid benefits that takes income into account. Taking withdrawals from retirement accounts may complicate the Medicaid application process. When it comes to either bankruptcy or Medicaid, you should to seek counsel from a qualified attorney on the best course of action. And do that before you take a nickel from your 401(k) plan.
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