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Don't take 401(k) withdrawals without considering these options first

Some millennials tap 401(k)s to pay down debt
Some millennials tap 401(k)s to pay down debt... 01:11

If you find yourself in a situation where you need money urgently and are considering taking a  hardship withdrawal from your 401(k) retirement plan, don't pull the trigger until you consider the pros and cons of several other options. Here are a few of the alternatives:

401(k) loans: If your 401(k) plan allows you to take a loan then it may be worth committing to a loan with a repayment schedule. Loans offer several benefits. For example, unlike hardship withdrawals, amounts borrowed from your 401(k) account are not taxable as income unless the loan balance remains unpaid. Also, you can replace the money you borrow from your 401(k) by making payments back to your own account, something you can't do with a withdrawal. Another advantage: The interest you pay on the loan goes back into your account, as well. 

But for some people, loans aren't an option because you must be actively employed by the employer who sponsors the 401(k) plan to be able to take loans from the employer's plan. Loans are generally not available to former employees who have left their 401(k) account in their former employer's plans.

Breaking down retirement bill SECURE Act 02:01

Finally, for folks who are already struggling with their current debt payments, taking a loan is not going to help as they will just have another payment to make.

 IRA withdrawals: As noted above, folks who have money in a former employer's 401(k) plan typically cannot take a loan from their 401(k) balance. That's one reason why people roll over a 401(k) into an IRA. The benefit of an IRA is that since it's not part of an employer's retirement plan, the IRA owner can take withdrawals from the IRA at any time and for any reason.

The downside of taking a withdrawal from an IRA is that the amount you withdraw is taxable as income. And if you are under age 59 ½, the amount withdrawn can also trigger an additional 10% penalty tax that applies to early withdrawals.

But in certain situations, you can take IRA withdrawals that are free from the 10% penalty tax for early distributions. These special situations include:

  • Payment of deductible medical expenses
  • First-time homebuying expenses
  • Payment of medical insurance premiums
  • Qualified higher education expenses
  • Distributions taken on account of disability or death

Again: A withdrawal taken due to one of these special situations will still be taxable as income, but it will at least avoid the additional 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 needs to pay health insurance premiums in a year they become unemployed. As long 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 additional early withdrawal penalty tax. 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 is advised to draw upon these accounts before taking money from 401(k)s or traditional IRAs or other retirement accounts where distributions would be taxable.

Protection from creditors: For folks who face more extreme financial difficulties, it may be advisable to consider other forms of creditor protection or benefits, rather than stripping cash from their retirement plans. The 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 wiser 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 your home and your 401(k) or IRA account.

Also, low-income individuals (including those who suddenly find themselves unemployed) who face sudden and large uninsured medical expenses may also qualify for a certain form of Medicaid benefits that considers primarily income. Taking withdrawals from retirement accounts may complicate a Medicaid application process that emphasizes income levels. When it comes to either bankruptcy or Medicaid, seek the counsel of a qualified attorney to provide legal advice on the best course of action and seek that counsel before you take any money out of retirement accounts.

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