Pulling Funds from 401(k) May Hurt Later
April 3, 2012 (USA TODAY) The three winners of the Mega Millions lottery have probably already figured out that come this time next year, they'll owe a face-melting tax bill. Lucky for them, they'll have lots left over after they come clean with the IRS.
Every tax season, though, lots of people who haven't won the lottery find themselves faced with a tax bill they didn't expect -- and don't have money to pay. For example, thousands of people whose credit card debts were charged off during the recession are now facing taxes on that forgiven debt. Others are learning that they owe taxes on their unemployment benefits.
A third category of taxpayers grappling with unwelcome tax bills are those who dipped into their 401(k) plans to pay the mortgage or other expenses. Hard times have led to a sharp rise in hardship withdrawals, particularly for African Americans and Hispanics.
Nearly 9% of African Americans took hardship withdrawals in 2010, vs. 3.2% of Hispanics and 1.7% of whites, according to a new study by the Ariel Education Initiative and Aon Hewitt. Two-thirds of African Americans and 57% of Hispanics who left their jobs in 2010 cashed out their 401(k) plans, vs. 40% of whites, the study found.
While the economy is slowly improving, many families have yet to recover from their own recession-related losses. But before you raid your 401(k) plan, it's important to understand how it will hurt your retirement security.
To start, your employer will withhold 20% of the amount withdrawn, says Ted Novy, assistant general counsel at Aon Hewitt.
In addition, most employees who take hardship withdrawals are also subject to a 10% early-withdrawal penalty, and employers don't withhold that amount, Novy says.
There are exceptions to the early-withdrawal penalty. You won't have to pay it if you're 59 or older, are totally and permanently disabled or used the money to pay for qualified medical expenses. Otherwise, you'll be on the hook for the penalty, "and that can be quite painful at tax time," Novy says.
Taxpayers who cash out their 401(k) plans when they leave their jobs could face a similar tax torpedo. As with hardship withdrawals, your employer will withhold 20% for taxes, and you'll probably owe an early-withdrawal penalty.
To avoid a tax bill, roll your former employer's 401(k) into your new employer's plan or an individual retirement account. A significant percentage of job changers don't choose this option, as the Ariel/Aon Hewitt survey found.
The trouble with loans
At first glance, a 401(k) loan may seem like a more sensible source of funds for emergency cash. The interest rate is low -- now about 4.25% -- and you pay interest to yourself, not a bank. You usually have five years to pay it off. And as long as you pay off the loan, you won't face any unpleasant tax consequences.
At the end of 2010, of workers with 401(k) accounts, 49% of African Americans, 40% of Hispanics and 26% of whites had a 401(k) loan outstanding. Employees use these loans for a variety of purposes, from paying off high-interest credit card debt to college tuition.
There's a serious downside to these loans. Borrowers who are laid off or quit their jobs are required to pay off the entire balance, usually within 60 days, says Pam Hess, director of retirement research at Aon Hewitt. Otherwise, the loan is considered in default.
The vast majority of workers who leave their jobs with a 401(k) loan outstanding are unable to pay off the balance, according to the Ariel/Aon Hewitt study. And because loans account for an average of 20% of the borrower's 401(k) balance, default results in a serious financial setback, the study said.
If you default on the loan, it will be treated as a distribution, which means you'll owe taxes on the entire balance, plus an early-withdrawal penalty if you're under age 59. Since you've probably already spent the money you borrowed, "you could have a real financial hurdle ahead of you," Hess says.
Borrowing from your 401(k) plan won't derail your retirement security if you dutifully pay yourself back, says Mellody Hobson, president of Ariel Investments.
"Unfortunately," she adds, "the best of intentions get undone when you go through a financial crisis."