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Retirement plans: 401(k)s and hardship withdrawals

By Jennie L. Phipps · Bankrate.com
Sunday, August 22, 2010
Posted: 11 am ET

Fidelity Investments, the nation's largest provider of workplace retirement savings plans, reported last week that in the second quarter savings were up, but hardship withdrawals from these 401(k)s also increased. Fidelity administers 17,000 plans, with 11 million participants. In the second quarter, some 62,000 employees initiated a hardship withdrawal, compared with 45,000 in the same period a year ago.

If you aren't familiar with hardship withdrawals, here's what the Internal Revenue Service says about them:

  • The withdrawal must be due to an immediate and significant financial need.
  • The withdrawal must be necessary to satisfy that need (i.e., the employee must have no other funds or way to meet the need),
  • The withdrawal must not exceed the amount the employee needs, including the amount required to pay taxes and penalties,
  • The employee must  first have utilized all distribution or nontaxable loans available under the 401(k) plan,
  • The employee can't contribute to the 401(k) plan for six months following the withdrawal.

Here is what the IRS considers acceptable hardships:

  • Unreimbursed medical expenses for the employee, spouse or dependents.
  • Purchase of an employee's principal residence.
  • Payment of college tuition and related educational costs such as room and board for the next 12 months for the employee, spouse, dependents or children who are no longer dependents.
  • Payments necessary to prevent eviction of the employee from his home, or foreclosure on the mortgage of his principal residence.
  • Funeral expenses.
  • Certain expenses for the repair of damage to the employee's principal residence.

Someone who takes a hardship withdrawal must pay taxes on the money, plus a 10 percent penalty if he is younger than 59 1/2 years old. Not all plan administrators allow hardship withdrawals, so if you are considering one, ask if it is possibility before you start counting your money.

Obviously, taking a hardship withdrawal isn't anybody's first choice. It's lousy retirement planning. But if you are in a really tough spot, there are a couple of pluses. You don't have to pay the money back, and no debt is going to show up on your credit report and haunt you for years.

The obvious downside is that you are robbing Peter to pay Paul -- shortchanging your retirement. Also, money in a 401(k) is usually protected in a bankruptcy. If you are on the edge and bankruptcy is a good possibility, don't take the money out of the 401(k) because that makes it fair game.

The Fidelity report has gotten a lot of attention, but it's worth doing the math. The Investment Company Institute, a trade organization of which Fidelity is a member, reported earlier this month that among the 24 million employer-based retirement plan accounts managed by its members as of March 2010, the share of workers taking hardship withdrawals dropped to 0.4 percent from 1.2 percent in the first quarter of 2009.

By comparison, Fidelity has 11 million participants of whom 62,000 took hardship withdrawals in the second quarter. That's 0.56 percent, a tad higher than the overall experience of all the members of the trade association, but when you're talking about numbers of this magnitude, it's a drop in the bucket.

It looks like, despite the Fidelity blip, hardship withdrawals are actually down compared to last year -- and that's good news.

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