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Extra cash from retirement hardship distribution: Right for you?

By David P. Barley Sr., CPA    

The economy has not been kind to individuals nor to businesses, and many people have found themselves in direira financial straits. Unemployment is on the rise; earnings are down; and credit is tight. Net worth has plummeted during the economic malaise. And your business may need extra cash.

What are you to do? These are difficult times that are requiring many people to make tough financial decisions.

If you offer and participate in a retirement plan, money is sitting in an account, seemingly locked up for many years unless you are willing to pay penalties for getting your hands on that money. What if you could get to that money? Would you? Or, more important should you?

Let us assume that you have taken every effort possible to improve your current personal economic situation by reducing overhead, trimming expenses, and improving cash flow. Now you see your last resort as invading the funds you put away for retirement.

You may have two options, depending upon your retirement plan: a loan or a hardship distribution.

• Loan. A loan is a required step before taking a hardship distribution. And, if your retirement plan offers loans, it would be a more expedient way to gain access to your funds.

Because a loan fails what is known as “constructive receipt”—a financial term used by the IRS, meaning that you do not have unfettered control of the loan proceeds—you are not liable for any tax or penalties on the money. Taking out a loan, however, has its downsides: You have to pay it back, and there are limits concerning how much you can take out of the retirement account. Some of these limitations are specific to the plan in which you participate, so you may need to check with your plan administrator.

Another issue regarding loans is what happens if you were to close your business and effectively separate from your employment. Some plans allow for you to continue paying the loans after you leave, but others require that you pay it back within a short number of days after you leave. If you do not pay the loan back as required by the plan, the loans are treated as a distribution and will be subject to taxes and possibly penalties.

• Hardship distribution.  According to the IRS, a hardship is an immediate and heavy financial need. The need can include the participant’s spouse and dependents. Facts and circumstances are used to determine immediate and heavy and these typically include medical expenses, the purchase of a principal residence, tuition and fees, avoidance of foreclosure on a principal residence, and funeral expenses. This list is not exhaustive, but is indicative of typical needs that meet the standard for a hardship distribution.

The hardship distribution is limited to addressing your needs, and you will not be able to contribute to the plan for at least six months.

Many people have IRA-based retirement plans such as a SIMPLE IRA. Generally speaking, hardship distributions are not allowed from IRA-based plans. That is because IRA owners can take distributions whenever they want to take them. Under certain circumstances, however, early distributions by individuals who are not yet 59½ years old incur a 10% penalty tax (25% for a SIMPLE IRA in the first two years).

If you are younger than 59½ you can avoid these tax penalties, however, if the distribution is to be used:

• To cover medical expenses in excess of 7.5% of your adjusted gross income;

• For the cost of medical insurance;

• Because you are disabled;

• To pay for qualified higher education costs, or

• To buy, build or rebuild your first home.

Times are tough; money is tight. As you try to figure out how to make it through to better economic times, consider taking money from your retirement savings as a last resort. If that is the route that you feel is in your best interests, you can get to get to your money. Exercise caution, though, because you are going to have to pay taxes on the distributed money, plus you are depleting your savings for your retirement years.

Disciplined savings in future years will be necessary to make up for the funds spent prior to retirement. Before taking any distribution from any retirement account, make sure to check with your tax and financial advisor to understand the consequences of your actions.

David P. Barley Sr. is principal of Barley, Martin & Wild, CPA, PL, www.bmwcpa.com, which provides financial planning and tax services to individuals and businesses. He can be reached at 904-694-4CPA (4272).

 

SIDEBAR 431

If an employee requests a hardship distribution…

A hardship distribution should be a last resort for anyone who participates in a retirement plan. If, however, an employee requests such a distribution, as an employer you should follow these seven steps, according to the Internal Revenue Service (IRS). (Most will be done by your plan administrator.)

1. Review the terms of your plan, including whether the plan allows hardship distributions; the procedures the employee must follow to request a hardship distribution; the plan’s definition of a hardship; and any limits on the amount and type of funds that can be distributed as a hardship from an employee’s accounts.

2. Ensure that the employee complies with the plan’s procedural requirements. For example, make sure the employee has provided a statement or verification of his or her hardship in the form required by the plan.

3. Verify that the employee’s specific reason for hardship qualifies for a distribution using the plan’s definition of what constitutes a hardship. For instance, the plan may limit a hardship distribution to pay burial or funeral expenses and not for any other reason.


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