Last resort: Raid 401(k) to beat foreclosure

You’ve heard the news: Foreclosures are up, home prices are down and even borrowers with good credit are increasingly late with their mortgage payments.

Previously, many of those borrowers would look to home equity as a resource to cover shortfalls. But with that option off the table for many, increasing numbers of people are considering tapping into a second large asset — retirement savings.

For some people, “It’s more important to have the cash in hand today than in retirement, which is a much more abstract goal,” says Brad Huffman, a Certified Financial Planner with Future Finances in Columbus, Ohio.

Most 401(k) plans and IRA accounts have rules in place that let you use your retirement savings to prevent foreclosure on your primary residence, either by offering loans on the balance or allowing you to simply withdraw the money.

“Congress wrote the rules so that in an emergency you can use the money to meet your needs,” says Stephen Utkus, director of Vanguard’s Center for Retirement Research. “The rules reflect a realism about our financial lives.”

About 85 percent of employees with a 401(k) have access to loans, and 89 percent of 401(k) plans will let you withdraw money if times get really tough, according to 401khelpcenter.com. A closer look shows 18 percent of workers had a loan outstanding from their retirement plan last year, according to the Transamerica Center for Retirement Studies. And the Employee Benefit Research Institute says approximately $320 billion in 401(k) loans were outstanding at the close of 2006.

But is tapping hard-earned dollars earmarked for your golden years a good idea?

Before you use retirement assets to bail yourself out of a housing crisis, there’s a lot to consider. It might not be the life raft you’d hoped it would be, and you could be making an irreparable dent in your retirement assets.

Option No. 1 — Borrow

If you participate in an employer-sponsored 401(k) plan, you likely have two options to get needed cash. You can either take a loan against your account balance or take a hardship withdrawal.

“There are no penalties or taxes on 401(k) loans, but you’ll miss out on market gains on the amount you’ve borrowed.”

The loan is the easiest to get. The rules vary from employer to employer, but in general you’re eligible for a loan of up to $50,000 or half of your vested 401(k) balance, whichever is less. The money must be paid back within five years, with interest. Payments start immediately, and usually are deducted from your paycheck. One important thing to keep in mind: Loans must be paid back with after-tax dollars, which could put a big dent in your ability to contribute pre-tax dollars to your 401(k).

There are no penalties or taxes on 401(k) loans, but of course you miss out on market gains on the amount you’ve borrowed.

If you quit or lose your job before the loan is paid off, you have 90 days to pay the remaining balance. If you don’t, you’ll get socked with a 10 percent early withdrawal penalty if you are younger than 59½, and you’ll have to pay income tax on the money you took out of the plan.

Option No. 2 — Withdrawal

Hardship withdrawals are much harder to get and come with stiffer penalties. Requirements vary from plan to plan, but in most cases you’ll have to prove that you are, in fact, facing a serious hardship.

IRS guidelines allow hardship distributions only for “immediate and heavy financial needs,” including medical and funeral expenses, college tuition costs, and to stop an eviction or foreclosure.

Each plan has its own rules governing how much of your account balance you can withdraw, and what you need to do to qualify.

In some cases, you may actually have to have a foreclosure notice in hand — not just be behind on your mortgage payments or facing a resetting interest rate — to qualify, says Rick Meigs, president of 401khelpcenter.com.

Other employers aren’t that strict. Only a visit to your company’s human resources department can clear up any gray areas.

If you do manage to qualify for a hardship distribution, you’ll have to pay income tax on any money you withdraw. And if you are younger than 59½, you’ll pay a 10 percent penalty for early withdrawal. You’ll also be barred from making any contributions to your 401(k) plan for six months.

“If your house is simply unaffordable, it’s better to lose the house than to risk the only other asset your family may have.”

For example, if you’re younger than 59½, take a hardship distribution of $10,000 and are in the 25 percent tax bracket, you immediately lose 35 percent of that money — 25 percent tax plus 10 percent penalty — or $3,500. The higher your tax bracket, the bigger the bite.

If you take money out of your IRA, the same penalties apply.

A loan is a much better deal, and won’t have as much impact on the amount of money you’ll have available when it’s time to retire, Meigs says. “The money is at least earning some sort of market interest rate and will eventually be returned to the account.”

That’s why some plans will only approve a hardship withdrawal after you have exhausted all of your 401(k) loan options.

With hardship distributions, you’re simply taking the money out with no concrete plans to return it. “That obviously can have a tremendous effect on the assets you’ll have available in retirement,” he says.

To tap or not to tap?

Now that you know your options, should you take advantage of them?

It depends. Using retirement money to keep up with the mortgage can be a good move for some people, but could dig others into an even deeper hole.

A loan or hardship distribution, “can be a good idea if it’ll get you to a place where you can refinance, or if you’re using it to buy time to get to a sustainable financial situation,” Utkus says.

But if your house is simply unaffordable — even if you refinance — “it’s better to recognize that fact early on, rather than sink the pension pot into the house,” says Anthony Webb, a research economist with the Center for Retirement Research at Boston College.

“If the house is eventually repossessed, you’ll lose all of your retirement savings, too.”

Figuring out which category you fit into isn’t necessarily easy. Most people tend to think their problems are temporary, even if they aren’t, Webb says.

A setback in your ability to pay bills, such as a short-term job loss or medical problems resulting in lost wages, likely qualify as temporary — if you’re on your way to resolving those issues — says Rich Call, vice president of housing with Consumer Credit Counseling Service of Central Ohio.

A sign of bigger problems? High credit card debt and a budget that can’t support the house even after cutting the fat and liquidating assets such as cars and savings accounts. In that case, “There might not be much you or the lender can do to save the house,” says Dianne Reichel, a certified credit counselor with GreenPath in Detroit.

If you have big problems, “don’t tap into money you’re going to need later. You’ll just be throwing good money after bad.”

Try other options first

Even if your mortgage problems are temporary, tapping your retirement assets to bail yourself out should be the last resort.

“Before you take the money out, try everything else,” Call says. “Even if you’re very serious about saving your house and you have no other money, (retirement assets) should be on the bottom of the list.”

Instead, see a HUD-certified housing counselor, nonprofit credit counseling agency or financial planner. They’ll be able to tell you where you can cut your expenses and what options, if any, you may have to save your house, Call says.

You might be able to refinance your mortgage or modify the terms of your existing loan rather than spend your retirement savings.

Options include a forbearance, a temporarily halt to mortgage payments that can give you time to get your finances in order. The missed payments are either added to the mortgage balance or tacked on to the end of the loan.

Lenders may also be willing to extend the number of years you have left to pay the loan, thus reducing your monthly payment, or substitute an adjustable interest rate for a fixed one. In rare instances, the lender may even reduce your loan amount to reflect a decline in the home’s value.

“Lenders are more willing to work with people than in the past because they’re getting stuck with houses they don’t want,” Reichel says.

If you’ve explored all of these options and you still feel like you need to tap your retirement savings to get out of a tough situation, “figure out if that money is really going to get you out of trouble,” Webb says.

“If the numbers don’t add up, it’s better to lose the house than to risk the only other asset your family may have.”

Denise Trowbridge is a freelance writer based in Ohio.

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