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In the wake of Hurricane Harvey, many Houston residents will be hit with huge repair bills and forced to dip in to any available source of cash. However, in that decision-making process, it is important to remember that some accounts and distribution types are costlier to use than others. Here I’ll lay out some of the options, and potential penalties, for accessing the money inside retirement accounts.
Permitted Hardship Withdrawal
On August 30th, the IRS announced it would be it would provide relief to taxpayers adversely impacted by Hurricane Harvey by allowing use of 401(k) assets to address hardships caused by the storm and easing the associated tax rules. However, this relief simply gives employers the ability to distribute cash to the plan participants impacted by Hurricane Harvey without asking a lot of questions, and without penalizing the company for violating the terms of the plan’s documents.
In other words, the IRS made it easier for employees to take money out of their 401ks to pay for repair costs. However, these distributions would still be subject to income tax to the employee and, if the employee is under age 59.5, a 10% penalty.
[Every 401k plan is unique to the employer so consult your HR department to determine your options.]
Also note, if your money is in an IRA, it can always be accessed without restriction (no rule change necessary). However, these funds will also be subject to income tax and, if the account holder is under age 59.5, a 10% penalty.
Loans v Withdrawals
In general, storm victims looking to tap their 401ks will be better off taking a loan rather than a withdrawal.
Unlike an IRA or Roth account, many 401ks allow the plan participants to take loans against their vested balances. The loan amount is limited to the lesser of 50% of the value of the 401k or $50,000. The loan is received by the account holder on a tax-free basis. The account holder then becomes responsible for repaying the loan over a specified period (returning the money to the 401k account). If the borrower fails to repay the loan, the unpaid portion is considered a distribution subject to income tax and, if the borrower is under age 59.5, a 10% penalty.
Again, loans are only available through 401ks and other similar accounts with an employer. They are not available on IRA or Roth accounts.
Generally, taking a loan from a 401k is a better option than taking a loan from a credit card, a pay day lender, or other short-term financing providers. In fact, in an emergency situation such as this, a 401k loan is often the quickest, simplest, lowest-cost way to get the cash needed to begin repairs.
Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on a borrowers credit rating. Assuming the loan can be paid back on time and over a short-term schedule, the loan will typically have only a small impact on the account holder’s retirement savings progress.
Distributions from IRA v Roth Accounts
In times of emergency, a Roth is going to be a lower cost source of funds than an IRA.
In a Roth account, contributions can be withdrawn at any time, tax-free and penalty free. (Meaning if you deposited $10,000 you can take out $10,000 at any time without tax or penalty.) Five years after your first contribution and age 59½, earnings withdrawals are tax-free, too. (Meaning if you deposited $10,000 but the account has grown to $12,000, you can take the $2000 of gains without tax or penalty as well).
On the other hand, with an IRA account, every dollar that comes out is subject to income tax as well as an early withdrawal penalty until age 59.5.
Do You Need Immediate Help Recovering from Hurricane Harvey?
If you have been impacted by Hurricane Harvey and need help figuring out your next financial steps, use the button below to schedule a completely free conversation with Jon Swanburg, our head of Financial Planning. We, like many of you, have been helped by so many in the community during this time of crisis and we are eager to pay it forward by offering financial guidance to those in need.
This is not for questions about investments but rather topics like: Who can you contact to reduce utility payments? How do you pay off the credit card debt that may pile up? Or What are the implications of taking a loan from the 401k to pay for repairs?