BOSTON (TheStreet) -- If you spend time at the beach this summer, you may notice the "current conditions" flags that warn swimmers about the water currents or surf. A red or black flag generally means it's too rough and one should avoid swimming; a yellow or orange flag typically signals light surf and advises swimmers to use caution; a green flag usually means calm waters.
With finances, we can use the same flags to help identify when it is a good idea to use a particular financial strategy or when the circumstances suggest it's best to avoid it.
Tapping into your 401(k) prematurely may be one of those "yellow/orange" flag circumstances. To avoid drowning in debt or another emergency situation, it may be tempting to access funds originally set aside for retirement. Proceed with caution, though. Before using your 401(k) as your life vest, review the conditions carefully to assess whether you should dive into your retirement savings funds or perhaps swim elsewhere.
First, you need to know the specifications of your particular plan to see what kinds of options you have. Some plans actually prohibit any type of distribution unless one terminates employment. Other plans are more flexible and allow participants to take loans and borrow against the plan or take advantage of "hardship distributions."
Depending upon your plan, it may make the most financial sense to take a loan rather than a hardship withdrawal because you generally would not have to pay income tax or another type of penalty. You must be aware of your specific plan's loan restrictionsm, however. Usually, among other stipulations, the loan must be repaid at a reasonable rate of interest, cannot exceed $50,000 and must be repaid within five years to avoid additional taxes or fees. And if there is a chance you may leave your place of employment in the near future, a loan may not be the best option. Often a firm will require you to repay loans from the plan immediately, sometimes within as little as 90 days of termination.
If your plan does not permit loans and you are truly facing an immediate financial crisis, you may be able to take what's called a hardship distribution from your 401(k) or other qualified retirement plan. Circumstances that qualify include medical expenses; purchase of your principal residence or to repair damage resulting from a natural catastrophe such as a hurricane; tuition and other related fees for college education; to prevent eviction from or foreclosure of your home; or payment of funeral expenses for family members.
If you are over age 59.5 and qualify for this type of distribution, the only tax you would have to pay is income tax on the distribution. But you do have to provide a detailed statement to the IRS that demonstrates you have exhausted other resources and proves that you truly have a "hardship."
If you are 59.5 or older and still working, another possibility may be to investigate whether your plan will allow you to do an "in-service withdrawal." In this option, you would be able to roll money out of your 401(k) into a rollover IRA (make sure you follow the strict rules for direct rollovers, though, to ensure you are not inadvertently taxed). Once the funds are in the IRA, you would be able to use them however you wish. Although you would still be required to pay income taxes, you avoid the burden of having to qualify and prove that you have a "hardship."
Probably the most unfavorable conditions for taking money out of your 401(k) or other qualified plan would be if you are younger than 59.5 and must take an early distribution. If this is the case, in addition to income tax, you will be subject to a 10% early withdrawal tax. For a distribution of $50,000, that would mean an additional $5,000 in taxes.
There are a few exceptions. For example, if you withdraw money to pay for medical expenses, the early withdrawal fee is waived -- although it's important to note that only the portion of your medical expenses that would be deductible if you itemized deductions on your tax return would avoid the early distribution tax. Thus, if you took $6,000 from your 401(k) to pay medical expenses before age 59.5 and $2,250 of those expenses were deductible on your income tax, the remaining $3,750 would be subject to the 10% early distribution tax, or $375.
As you can see, taking money out of your 401(k) plan or other qualified plan can be complex and not without its consequences. Like a swimmer at a beach, make sure you test the waters and proceed with caution before assuming your 401(k) will keep you afloat.
Greg Plechner is a CFP and a principal at Modera Wealth Management LLC, based in Westwood, N.J., and Boston and a member of NAPFA, the National Association of Personal Financial Advisors.
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