The problem
Mr. Overextended purchased his home in late 2005 at the peak of the housing boom. He and his wife have borrowed heavily against the house to make significant upgrades.
His wife recently lost her job and the couple has fallen behind in making their high mortgage payments.
Even if they decided to put their house on the market, the couple would never break even in the current economic downturn.
Mr. Overextended has a 401(k) account with his employer which has a $100,000 balance. He is 50 years old and wants to know how he can access his account to reduce his expenses.
Other reasonable avenues to raise cash have been exhausted, and Mr. Overextended now needs to know what it will cost him in taxes and penalties to make a withdrawal from his 401(k) account.
The solution
The last frontier for raising cash in tough times is retirement savings. But if you are presented with the scenario in which your client needs cash and they want to raid their retirement money for a “hardship distribution,” you need to know the rules.
For active employees under age 59 1/2 there are only two ways to tap 401(k) accounts: The first is to take a loan from the plan. But keep in mind that not all plans allow loans. The second way is to take a hardship withdrawal.
Distributions are treated as a hardship only if they are made on account of an immediate and heavy financial burden and are necessary to satisfy that financial need. While this definition is broad, the
Internal Revenue Service does offer some guidance to help in the determination.
The Internal Revenue Code allows a distribution to pay for medical care that would normally qualify as a tax deduction. Additionally the cost of purchasing a principal residence will qualify.
Other hardship distributions are allowed for the payment of tuition, related educational fees and room and board expenses for up to 12 months of post-secondary education for the employee, spouse, children or dependents.
Three other situations qualify for a hardship distribution. The first are payments that prevent an employee’s eviction from their principal residence. Second are payments for burial expenses for the employee’s parent, spouse, child or other dependent. Lastly, payments to repair damage to the employee’s principal residence that would otherwise qualify as a casualty loss are allowed.
Any distribution made as a hardship withdrawal is fully taxable as ordinary income in the year the hardship distribution is received. Additionally the distribution is subject to a 10% penalty tax.
There are limited exceptions to the 10% penalty — namely, the exception applies only to medical expenses.
Because Mr. Overextended faces the loss of his principal residence, he will be able to take a distribution from his 401(k) plan. Eviction or foreclosure from a principal residence is an allowed hardship withdrawal.
Mr. Overextended determines that he needs $40,000 in order to avoid foreclosure and qualifies for a hardship withdrawal for that amount. When he gets the money he will have to pay income taxes on the $40,000 at his tax bracket. Furthermore, he will be subject to a $4,000 penalty tax.
Also, Mr. Overextended is not allowed to make any elective contributions to the plan for six months.
If a client asks about withdrawing from their 401(k) account, you should advise the client to exhaust all available means before considering a hardship withdrawal. You certainly don’t want to create future hardship if you can avoid taking this step today.
Kenneth J. Strauss is director of tax and personal financial strategies at Berkowitz Dick Pollack & Brant LLP of Miami.
Read more about the increase in mortgage-related hardship withdrawals in this
research note>from Vanguard Center for Retirement Research.
Tax INsight is prepared by experts who are active members of the American Institute of Certified Public Accountants. Tax INsight appears on the web and in IN Daily every Tuesday. Comments are welcome at
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