Taking From 401(k) For Mortgage: Bad Idea

The downturn in the economy is forcing some people to do something drastic -- take a "hardship withdrawal" from their 401(k) to pay their mortgage. The Early Show's financial expert, Ray Martin, says in this column that such a move is a big mistake.

The recent reports indicate that more and more of the withdrawls are of a special type, known as "hardship withdrawals."

Several large retirement plan administrators say the most common reason cited for taking those withdrawals is to prevent foreclosure on the mortgage of, or eviction from, a home.

Hardship withdrawals are different from loans, in that they are taxable as income and do not have to be repaid. Hardship withdrawals, which are widely available in most 401(k) plans, allow individuals in certain situations to take money from their 401(k) plan accounts while they are still working with the employer who sponsors the plan.

Hardship withdrawals may be taken from a 401(k) plan only if the plan allows such withdrawals, and only if the funds are needed to meet an immediate and heavy financial burden -- for instance, if you cannot get the money needed from any other reasonable source.

According to government rules, hardship withdrawals are permitted for the following reasons: medical expenses that exceed 7.5 percent 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 the need to prevent eviction or foreclosure of the mortgage on a primary residence.

There are several downsides tof taking hardship withdrawals from a 401(k) plan.

The amounts distributed are taxed as ordinary income and, if the individual is under age 59-and-a-half, an additional ten percent penalty will apply to the amount withdrawn. Also, about 85 percent of employer 401(k) plans bar employees from making 401(k) contributions for six months after taking a hardship withdrawal. Amounts taken from a 401(k) plan in the form of a hardship withdrawal cannot be repaid or put back into the account. Finally, employers often require an employee to provide a written representation of their reason for requesting a hardship withdrawal and why the need cannot be satisfied from other reasonable resources -- and that means employees have to reveal their personal and private matters.

If your 401(k) plan allows you to take a loan, it may be wise considering doing so. Unlike hardship withdrawals, amounts borrowed through a 401(k) plan loan are not taxable as income unless the balance goes unpaid. Also, you can replace the borrowed money by making payments back to your own account.

But 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 to former employees who have left their 401(k) account in their former employer's plans.

For some folks, the unfortunate reality is that if they truly need to take a hardship withdrawal, taking a loan instead is not going to help: They would just have another loan payment to make.

But individuals with a 401(k) plan account who are facing financial difficulties and are no longer with their former employer and typically cannot take a loan from their 401(k) plans should consider transferring the funds in their 401(k) account to an IRA. That's because, under certain circumstances, hardship withdrawals that are free from the ten percent tax for early distributions can be taken from an IRA.

There are nine special situations where withdrawals can be taken from and IRA that are excluded from the 10 percent early withdrawal penalty tax. These include disability, death, payment of non-reimbursed medical expenses, first-time purchase of a home, payment of qualified higher education expensesm, and withdrawals used to pay for medical insurance premiums.

While IRA withdrawals taken due to those special situations would be taxable, they would be free of the additional 10 percent penalty tax. And in certain situations, it may be wise to do that. For example, say an individual has an IRA and also needs to pay health insurance premiums in a year when 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 followingm unemployment, then the withdrawal could be exempt from the additional 10 percent 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 true hardship situations, it may be advisable to seek other forms of financial relief, rather than stripping cash from their retirement plans. One 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 better to preserve those protected assets and get the bankruptcy process under way sooner. And, since many states provide some exemption for your home after bankruptcy, you'd still own that and your 401(k) or IRA account.

Also, low income individuals (including those who suddenly lose their jobs) who face sudden and large uninsured medical expenses may also qualify for a certain form of Medicaid benefit that takes into account primarily income. Stripping out cash from retirement accounts here may be unnecessary, and it may be advisable to get the Medicaid application process going. In both situations, it's advisable to seek the services of a qualified attorney to provide advice on the best course of action, before takinge a nickel from your 401(k) plan.