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IRA Withdrawals: Some Relief for Hardships

I often get questions from readers about their personal finance issues. Periodically I'll answer them here. If you have questions you'd like to ask, please email me by clicking on the "Contact Ray Martin" link to the left.

Hi Ray, I enjoy your segments on the Early Show. I lost my job of 25 years in mid 2007, and I received a modest severance. I activated my pension at 90% when I turned 60 in Sept. 2007. In 2008 I worked at a low-paying job for 4 months. Late in 2008, I was awarded Social Security Disability Insurance, with the first payment in Jan. 2009.

After watching my 401-k funds dive in 2007, I finally rolled over to a traditional IRA. I took $25,000 in distributions in 2008 and $17,000 in 2009 just to make ends meet. My taxes owed in 2009 (about $4,600 so far) is about twice what I've paid already.

Is there any relief for losses of retirement savings due to market losses? Or any leniency for taking distributions to pay the bills? Thanks for your time, John Hamilton.
Dear John,

If you had contacted me back in 2007, I would have told you to consider keeping your balance in your 401(k) plan. The reason is that 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. When you left your employer, you could have used some of your severance money to repay the 401(k) loan.

For some people, this is not an option because 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. Also any outstanding loans typically must be repaid soon after you leave your employer, or the unpaid balance is a taxable withdrawal.

For some folks, the reality is that if they truly have a financial hardship, taking a loan instead is not going to help. They will just have another loan payment to make.

But individuals with a 401(k) account who are facing financial hardship and are no longer with their former employer often cannot take a loan from their 401(k) plans. Folks in this situation should consider transferring their 401(k) account to an IRA. That's because in certain situations, hardship withdrawals can be taken from an IRA that are not subject to the ten percent tax for early distributions. There are nine special situations where withdrawals can be taken from and IRA that are excluded from the early withdrawal penalty. These include disability, death, payment of non-reimbursed medical expenses, first time purchase of a home, payment of qualified higher education expenses, and withdrawals used to pay for medical insurance premiums.

While IRA withdrawals taken on account of these special situations will be taxable, they will avoid the additional 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 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 10% early withdrawal penalty. To properly report penalty-tax free withdrawals from an IRA, you'll need to complete IRS form 5329.

Finally, for some folks in extreme hardship situations, it may be advisable to take another course of action instead of taking withdrawals from their retirement plans. Under federal law, when individuals file for bankruptcy, their 401(k) account and IRA are excluded from creditor judgments. So if bankruptcy is inevitable, rather than spending down retirement assets it may make sense to 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 benefit that primarily takes into account income. Stripping out cash from retirement accounts here may be unnecessary, and it may be advisable to get the Medicaid application process underway.

In both situations, it's a good idea to seek the counsel of a qualified attorney to provide legal advice on the best course of action, before you take a nickel from your 401(k) or IRA.

In response to your second question, John, unfortunately there is no tax relief for investment losses in retirement accounts.

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