401 (k) money should be the last resort for disaster victims
Imagine it’s Wednesday afternoon and you’re on the downside of your work week. You’re looking forward to working in the yard, taking in a ballgame or perhaps a round of golf on the coming weekend. Off in the Atlantic there is a tropical storm but the forecasters predict it will spin harmlessly off the coast, trailing back into the mid-Atlantic. By Friday the forecast has changed and it’s bearing down on you. A disaster looks imminent, so what do you do?
With the recent hurricanes, this question gains importance. Don’t live by the ocean? It could be a tornado, an earthquake or a 100 year storm that brings flooding. The next thing you know you have suffered a major casualty loss.
Financially what should you do?
First off there are a few things you should not do. Number one is to tap your retirement account to repair and rebuild. Why one might ask? It’s my money and I need access to it. For some with little or no assets besides their residence, that may be the only option. For those that have a choice, other financial resources should be considered before tapping your retirement savings. Below we will detail several reasons people tend not to think about when they start to access their retirement account in a disaster.
First, if you take a plan loan to help with rebuilding, you will be repaying the loan back with after tax money, including the interest you are paying yourself. Additionally the borrowed money is no longer invested. So, you permanently lose the returns associated with the money you borrow while it is out of the plan. Finally, when you withdraw the repaid loan money in retirement, you will owe taxes again on the amount repaid. In effect by borrowing from the plan, you will pay tax on the money twice. Once when you pay the loan back with after-tax dollars; again when you pay tax on the plan distribution.
Let’s look at the math.
Say you need $6,500 to fix your roof. You take out a 5 year loan from your retirement plan. If you are paid every two weeks, the payment at 5% interest will be $61.34. At a 25% tax rate, you need to earn $81.79 before taxes to make this payment. Why you might ask? Because you are using after tax money to repay the pre-tax money used in the loan. Over the life of the loan you will need to earn about $9,700 in pre-tax money to pay off the loan principle and interest of $7,274.72. And this $7,274.72 is subject to tax a second time when distributed from the plan.
If you decide to take a hardship distribution the effect can be just as bad. Your distribution will be taxed as ordinary income and if you are under age 59 and ½ you will also owe the 10 percent early withdrawal penalty on the hardship withdraw. Plus you will lose the compounded returns the money could have earned over the years had it stay in the plan. Also, if you are in the 25% tax bracket, you are only getting 65 cents on every dollar you pull out.
What? It works like this. If you take a $10,000 hardship from the plan, you would typically owe about 25% in tax or $2,500. Add in the 10% early withdrawal penalty of $1,000 and your $10,000 withdrawal is now only worth $6,500 or the cost of your roof repair.
As you can see from these examples, tapping a retirement plan should not be a first choice, or even second choice, for funding in a disaster. Another point to consider, depending on the state you live in, taking a retirement distribution may affect your eligibility for drawing unemployment if your employer is forced to lay you off due to the disaster.
If you have questions, we are here to help. PAi’s 401(k) services stay on top of current and pending legislation that may affect your 401(k) or your retirement goals. This means you have more time to spend on what’s most important to you. Let’s start with a conversation. Contact us online or give us a call to get your plan started: 800.236.7400.
Kent Wright – Due Diligence and De-accumulation Analyst – firstname.lastname@example.org – 800-236- 7400 x 3252
Kent is a subject matter expert on 401(k), retirement accounts, investments, and financial services. Kent is also a published author.
John Nahacky, JD, CPC - Compliance Manager - email@example.com - 800-236-7400 x3250
John is the subject matter expert on 401(k) rules, regulations, compliance, plan design, and year end requirements.