When Facing A Financial Hardship, Don’t Dip Into Your Retirement Plan To Fix It
If you look at your balance sheet and have an employer-sponsored retirement plan, there’s a fair chance that it’s one of your largest assets. This can lead many people to view their retirement plan as a resource when it comes to addressing major financial hardships. Let’s discuss why a retirement plan should be a last resort in these situations, how to reduce the burden of financial setbacks, and other ways to fund this need.
Why A Hardship Withdrawal Should Be A Last Resort
Let’s consider a hypothetical 35-year-old single investor. He makes $85,000 per year, has a 401(k) worth $100,000 today and experiences a serious hardship. His home burns down in a fire and he doesn’t have any insurance to repair/replace the home or his belongings. He withdraws the entire $100,000 from the 401(k) and uses it to rebuild his home.
What are the consequences of this?
His federal marginal tax bracket would increase from 22% to 32%.
If he lives in a state with an income tax, that bracket would also likely increase.
This hardship would be subject to an additional 10% tax penalty. (Exceptions from the IRS are here).
He would lose out on years of compounding interest in his account. If he left the $100,000 invested and received a hypothetical* 10% annual return, it would be worth $1,744,940.23 by his age 65.
So, the investor ends up with around half of his saved 401(k) and is set severely behind for his future retirement goals.
How To Reduce The Burden Of A Financial Hardship
Two major things you can do to minimize the impact financial hardships are maintaining adequate emergency funds and having sufficient insurance for various risks you face.
In the sample investor’s case, his financial setback could have been completely avoided if he’d had adequate fire insurance coverage. The intention of insurance contracts is to reduce the financial burden of accidental losses. Some other major financial hardships that could be resolved with adequate insurance coverage are:
The death of a family’s breadwinner (life insurance).
The inability to continue to work or care for yourself (disability income and/or long-term care insurance).
A major illness or injury for you or a dependent (adequate health insurance coverage).
Losses resulting from a car accident (adequate car insurance coverage).
Lawsuit following an injury on your property (homeowner’s insurance and umbrella coverage).
Lawsuit for professional recommendations you’ve given (errors and omissions insurance).
While in the sample case, an adequate emergency fund would have been unlikely to cover his full financial hardship, an emergency fund covering 3-6 months of expenses can often be effective in giving some time, options, and short-term liquidity.
If his monthly expenses were $4,000 per month and he had a 6-month emergency reserve, he would have had $24,000 on hand to cover some of the most pressing expenses, like securing housing and taking care of some of his essential needs. This would have also significantly reduced the amount he needed to take from his 401(k), thus reducing taxes and fines, as well as allowing some of the funds to continue getting those compounding returns.
Other Ways To Fund A Financial Hardship
If you’re currently experiencing a financial hardship, it’s too late to gain insurance coverage or build up an adequate emergency fund for the setback that has already occurred. But you can put these in place for future unexpected events.
If you have any funds in a bank account or a non-retirement account, dipping into those dollars is preferable to touching your retirement account.
If you are truly experiencing a financial hardship that you are unable to pay for, there’s a chance that one of the existing government programs covers your hardship for temporary relief. Those include Medicaid, Social Security Disability and Temporary Assistance for Needy Families.
In the sample investor’s case, he may be able to get a loan from a family member or bank that would have a lesser financial impact than a hardship distribution from his 401(k).
Lastly, those with loan options in their 401(k)s can opt to take a loan as opposed to a hardship distribution. The sample investor may have been able to take a loan of 50% of his balance up to $50,000. If his loan were paid back on schedule, he would avoid the taxes and penalties, but lose out on some of the compounding returns along the way. I mention this loan step last because this option too often can go in the same direction as hardship withdrawals in my experience. Investors can forget to pay these loans back and must pay taxes and penalties whenever the IRS catches it, which could end up being a separate — and surprise financial hardship.
Conclusion
Financial hardships can be potentially devastating both in the present and on your future self if treated improperly. To minimize their impact, consider reassessing your insurance coverage for various risks and building up an emergency fund. If you experience an unexpected event, consider dipping into non-retirement accounts, assessing your eligibility for government programs, and gaining a loan to cover the temporary need before turning to your 401(k).
