Wiles: Why you shouldn't tap into your retirement plan after disasters

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When disasters like Hurricanes Harvey or Irma strike, it's tempting to tap into 401(k) or other retirement plans, but

In the wake of a disaster like Hurricanes Harvey or Irma, a job loss or other financial trauma, it's natural to look to 401(k)-style retirement plans or Individual Retirement Accounts for help.

Retirement plans are among the largest sources of fairly liquid, non-housing money available to millions of Americans. They are tempting sources of ready cash.

The Internal Revenue Service recently acknowledged as much, reminding Harvey victims with 401(k) accounts that they could tap these plans in a pinch. In fact, the IRS is relaxing certain retirement rules, making it easier for people in disaster areas to pull money out.

However, the agency isn't easing the associated tax bite, including penalties, that can arise. "The tax treatment of loans and distributions remains unchanged," the IRS noted.

Taxes are a big reason why retirement accounts usually aren't good places to turn for quick cash. Taxes, penalties, plan complexities and opportunity costs can turn withdrawals, and perhaps even loans, into bad decisions.  

Borrowing from your account

wiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 1 Here are six strategies that retirement-focused investors can take on their own — steps that many people routinely ignore.  Getty Images/iStockphotowiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 2 Delay Social Security: The longer you wait, the higher your monthly benefits will be when you start collecting them. At a minimum, one adviser suggested, people should defer Social Security until full retirement age (66 or 67 for most people now in the workforce).  Getty Imageswiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 3 Start saving earlier: Starting early and investing in a 401(k) allows investors to tap into the powerful effects of compounding, or earning interest on interest. Investors should strive to save at least 10 percent from each paycheck.  Getty Images/iStockphotowiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 4 Boosting returns: Build a diversified portfolio with stocks or stock funds at the foundation, especially for young adults but even for people at later ages. Keeping too much in conservative, low-yielding assets offsets much of the benefits of saving regularly and starting early.  Getty Images/Hemerawiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 5 Saving more: Most people do earn more over time, so boosting the savings rate for a 401(k) is feasible. More employers with 401(k) plans are starting to "auto escalate" contributions — diverting more worker pay into their retirement accounts unless workers opt out.  Getty Images/iStockphotowiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 6 Raising the match: Employees also will fare better if companies offer more money in matching funds. Of the six factors, this is the only one that investors don't control.  Getty Images/Blend Imageswiles-why-you-shouldnt-tap-into-your-retirement-plan-after-disasters photo 7 Cutting fees: "Fees have to be reasonable," especially in retirement plans, said Tom Kmak, CEO of Fiduciary Benchmarks.  Getty Images/iStockphoto

Generally, it's smarter to take a loan against a portion of your 401(k) retirement money than to pull it out permanently as a withdrawal. As long as you repay the money (generally within five years), you don't report loan proceeds as taxable income. That also means no 10 percent early withdrawal tax penalty.This penalty often applies when people cash out retirement money prior to age 59 1/2.

Yet loan requirements vary, and 401(k) plans aren't required to allow borrowing. While many do allow loans, they're typically capped at a percentage of a person's vested balance, up to $50,000 maximum.Some plans don't allow participants to have more than one outstanding loan. So if you had borrowed previously, you could be out of luck if a disaster struck and you needed more cash.

If you have a traditional IRA, you can't borrow from it, though the IRS said it is relaxing some rules, making it easier for hurricane victims to get at this money. You can withdraw money from traditional IRAs, but in general, these distributions would be taxable and subject to the 10 percent penalty for people under 59 1/2, with some exceptions.

Roth IRAs also don't allow loans, but money representing contributions — the amount you invested — can be withdrawn tax-free at any time. The portion representing investment earnings on Roth accounts also can be tapped tax-free if an account has been open at least five years and you're at least 59 1/2 — or if certain other requirements have been met, such as using the money for a first-time home purchase.

Loan pros and cons

Loans from 401(k) plans can look plenty enticing in a pinch. There's no credit-approval hurdle, and applications are simple, making the process quick and convenient. Fees usually are minimal, and you pay the interest back into your account, not to a bank or other lender. Interest rates on 401(k) loans, often pegged to the prime plus 1 percent, are lower than on many other types of non-housing debts.

Still, a loan means pulling money from your retirement account, even if only temporarily, and you would pay it back with after-tax dollars. Repayment could become problematic if you lose your job or leave voluntarily. When employment is severed, the balance comes due fairly quickly, often within two months. If you couldn't pay it back, the balance becomes taxable, possibly triggering the 10 percent penalty if you're under 59 1/2.

This last risk can't be understated, especially after an emergency. Job security is difficult enough to predict in normal times. In the wake of a disaster, things could become more muddled — both for you and your employer.

Pulling it out permanently

Still, taking out a loan usually is preferable to taking an outright withdrawal. Once a distribution becomes permanent, the funds become taxable, with the 10 percent tax penalty usually tacked on for people under 59 1/2. For those ages 62 and up who also are drawing Social Security retirement income, a large withdrawal could be enough to push some of their Social Security benefits into the taxable category.

As with loans, not all 401(k)-style programs allow hardship withdrawals prior to retirement age, so it pays to check on this before the need arises.

Roth IRAs, as noted, is an important exception. Withdrawals of contributions wouldn't be taxable or subject to the 10 percent penalty. But Roth earnings could be taxable if you're under 59 1/2 and haven't held the account at least five years.

Missed opportunities

To the extent employees take out 401(k) loans, the borrowed money wouldn't be available to generate possibly high returns. It would earn something, as participants do pay interest back into their accounts (currently around 5 percent). But that could be a lot less than the potential gains available if the stock market rallied during the loan period. So too with withdrawals, with the increased likelihood that withdrawn money would never find its way back into a retirement account.

Financial advisers routinely suggest that Americans build up an emergency fund, held separately from their retirement accounts, capable of meeting at least three to six months of expenses. Tapping an emergency fund usually is the best option when disaster strikes.

Outright withdrawals from retirement plans rarely are a smart move. Loans might be a reasonable option, but you should understand their many intricacies before taking the plunge. In the aftermath of a disaster, there will be more pressing problems to worry about. The last thing you want to ponder are the various account restrictions, tax implications and other consequences of such a move.

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.

 

 

 

 

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