Taking Withdrawals from 401(k)? Consider Alternatives First
Earlier this week I wrote about the downsides of taking hardship withdrawals from a 401(k) plan. I recommend folks to consider these alternatives before taking a hardship withdrawal from their retirement plan accounts.
401(k) Loans: If your 401(k) plan allows you to take a loan then it may be considering. 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 for former employees who have left their 401(k) account in their former employer's plans. For folks already struggling with their current debt payments, taking a loan is not going to help as they will just have another payment to make.
Regular IRA Withdrawals: Folks with a 401(k) plan account and 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, folks can take withdrawals that are free from the ten percent tax for early distributions from an IRA. These special situations where IRA withdrawals avoid the 10% 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 upon disability or death.
While a withdrawal taken on account of one of these special situations will be taxable, it will avoid the additional 10% penalty tax. And in certain situations, it may even be advised 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 this IRS form.
Roth IRA Withdrawals: Because contributions to a Roth IRA are made with after-tax dollars, folks 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 other retirement accounts where distributions would be taxable.
Bankruptcy Protection: For some folks in extreme hardship situations, it may be advised to seek other forms of financial protection, rather than striping 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 advised 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 that and your 401(k) or IRA account.
Also, for 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 takes into account primarily income. Taking withdrawals from retirement accounts may complicate the Medicaid application process. When it comes to either bankruptcy or Medicaid, it's advised to seek the counsel of a qualified attorney to provide legal advice on the best course of action. Do so before you take a nickel from your 401(k) plan.
Ray Martin
View all articles by Ray Martin on CBS MoneyWatch»
Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.
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