Cash-strapped employees are turning to their retirement plans as the credit crunch drags on and costs for everyday necessities continue their upward spiral. While hardship withdrawals from 401(k) plans are taken by a very small number of participants — about 1.5 percent at Vanguard — the giant fund company says hardship withdrawals have been increasing significantly; up about 17 percent in 2006 and another 9 percent in 2007.

“We would say from our data that the big uptick began earlier than the subprime crisis, which indicates to us that it wasn’t a lagging indicator, it was a leading indicator,” says Stephen Utkus, director of Vanguard’s Center for Retirement Research. “When people started to have difficult times, they started tapping their 401(k) plan for various hardships and then, later, the subprime crisis manifested itself. We fully expected them to be up a little in 2006 and then really up in 2007 when, in fact, the big growth rate occurred in 2006. This suggests to us it’s much more an issue of financially stretched households and not so much a subprime issue.”

It’s not hard to imagine that people who took on more mortgage debt than they could handle began looking to their retirement accounts to keep their heads above water.

Hewitt Associates tracks 1.5 million 401(k) participants at large corporations and says the trend for hardship withdrawals is continuing in 2008, and they don’t expect to see that trend change throughout the rest of the year.

The number of loans from 401(k)s are holding pretty steady around 22 percent of participants at any given time, according to Pam Hess, director of retirement research at Hewitt.

“We did find that in 2007 and so far in 2008 the number of people initiating new loans is marginally higher, but they’re shorter-term so they’re paying them off quicker. But 22 percent of people with loans is a lot. That’s always been one of our concerns. If it’s a one-time thing and they really need the money and they’re going to repay it in a couple years and they keep contributing to the plan so they get the company match, then some loans might be OK for a short-term solution.”

IRS rules for withdrawals

Hardship withdrawals are allowed under IRS rules for “immediate and heavy financial need” that meets certain criteria.

If the criteria are met, a hardship withdrawal can include the amount of the employee’s elective deferrals. Employer contributions may be included depending on the company plan. Keep in mind that withdrawals are taxed as ordinary income; plus a 10 percent penalty.

You can’t put the money back into your 401(k) once you get back on your feet — and in most cases you’re not permitted to contribute to your plan for six months after the withdrawal. That principal and the opportunity for compounding are lost forever and may have a significant impact on your retirement fund.

Loans depend on company

Loans from 401(k)s are allowed under IRS rules, but not all company plans permit them. Generally, an employee may borrow up to half of the vested balance to a maximum of $50,000. The loan must be repaid within five years unless the money is used to buy a home. The loan isn’t taxed, but you repay it with interest which is credited to your account. If you leave the company, you must repay the loan right away or it’s considered a withdrawal and is taxed and penalized.

“Congress did not prohibit hardship withdrawals, did not prohibit loans and did not prohibit you touching your money when you change jobs,” notes Vanguard’s Utkus. “The tax policy in the U.S. is designed to create disincentives but never prohibitions.

“There’s a good argument to be made for absolute prohibitions because you want to protect retirement savings, but I think economists persuaded Congress that sometimes there are worse things than not saving for retirement and those include losing your house, unemployment, huge medical expenses and financial catastrophe. Sometimes if the only asset you have is your 401(k) savings, it’s economically sensible to use it for other purposes.”

Think before you tap

Before you tap your 401(k), take time to see if there are alternatives. Your retirement plan should be the last resource you consider.

Steve Juetten, Certified Financial Planner and principal at Juetten Personal Financial Planning in Bellevue, Wash., has several steps that he advises people to take before tapping a retirement plan during a financial crisis:

Review the last 6 months of expenses and classify them into needs and wants. “Most people spend about 80 percent of their income on seven or eight main categories, such as food, clothing, shelter, gas, insurance and the like. There isn’t a lot of variability in that. It’s the other 20 percent we’re going after. After you’ve separated the needs from the wants, stick to a plan that spends only on the things you need, not the things you want.”

Stop 401(k) contributions. “If you have to stop, then stop. Just make the commitment that you will go back to it at a point and stick with it. This is a very short-term approach. Let’s take care of the emergency we have right now. Let’s do what we have to do to keep body and soul together, but we need to get back to savings when this crisis is over.”

Involve the family. “The kids need to be involved, both parents need to be involved, whoever your family is — let them know what’s going on, what you’re doing and how everyone can contribute. Pennies add up to dollars and dollars add up to many dollars. Everybody can help.”

Make minimum payments on credit cards. “If you have credit card debt and you stop paying, it will affect your credit rating. Make the minimum payments and make them on time.”

Take a loan rather than a hardship withdrawal if you can. “Everybody’s situation is different, and if you’re really strapped, you may need to take the hardship withdrawal because you start repaying a 401(k) loan immediately and it comes out of the paycheck. Don’t take a bigger loan than you need just to cover the initial payments. If you’re going to take a loan, stop making contributions. But a hardship withdrawal is taxed and there’s a penalty, and you need to take that into account.”

Even people who are getting through the current crisis relatively unscathed should make sure their emergency funds are adequate. Employees may not be fully aware of how much cost increases are impacting their companies, and a job loss can happen whether or not you expect it.