Hardship withdrawals from retirement plans, such as 401K plans, nationwide have reached a ten-year high, according to a report issued last week by Fidelity Investments which administers about 17,000 plans across the country covering some 11 million participants.
In the second quarter of this year, about 62,000 workers asked for withdrawals from retirement plans to pay medical expenses, costs to purchase or repair a primary home, tuition and education expenses, burial or funeral expenses, or to prevent an eviction or foreclosure on a primary home.
Even worse, besides withdrawals, more and more people are taking loans from retirement plans. A two percent increase in the second quarter now means that 22 percent – almost a quarter of all participants — have outstanding loans against their accounts.
It’s a risky and sometimes financially-disastrous game for consumers. Too often, in my fifteen years of bankruptcy practice in the Washington-DC area, I have seen people needlessly lose their retirement, and worse, dig themselves into a deeper hole.
There are several typical scenarios:
- To stop collectors from hounding him, the debtor takes a lump sum withdrawal to pay off his bills. Unfortunately, many do not subtract withholding taxes from the withdrawal. When the end of the year comes, the debtor does not have the cash to pay the income tax plus the additional 10-percent penalty. The debtor has now turned his debt problem into a more serious tax problem.
- The debtor takes a loan to pay off debts or make payments on debts, and then as his income situation deteriorates, he defaults on the 401K loan payments. At the end of the year, a “distribution” (equivalent to a withdrawal) is declared. The full tax and 10-percent penalty on the loan is now due.
- To stop a foreclosure or mollify creditors, the debtor takes out a loan or withdrawal to make the minimum payments on installment loans or pay the mortgage. The saddest cases are person who drain retirement funds, which are generally protected in bankruptcy, to make minimum payments on debts that never go away, or the house goes into foreclosure anyway when the money runs out. In most cases the debt could have been discharged in bankruptcy from the very beginning and he still would have kept the tens and hundreds of thousand he had saved for retirement. The debtor “ate his seed corn” for nothing!
Tax debts are what I call financial cancer. Besides accruing interest, unpaid taxes also accrue penalties so that the liability grows at a double-digit rate. Even worse, the IRS is a serious creditor with powerful collection powers not available to private collectors. Private collectors are limited as to how much of a paycheck they can garnish. In Virginia, the limit is 25%. IRS is generally not so restricted. We have seen IRS garnishments leave a debtor with a few hundred dollars in a paycheck. IRS does not have to take you to court. IRS can proceed to wage and bank account garnishments directly and bypass the court.
Think long and hard before you take a withdrawal or loan from your 401K.
- Am I merely throwing away my retirement trying to forestall the inevitable? What’s the likelihood I will need to file bankruptcy eventually anyway?
- Am I likely to get a job soon and this withdrawal is just to tide me over?
- Are the debts so large that merely making the minimum payment will not pay the debt down significantly?
Be honest with yourself. Talk it over with an experienced professional. Depending on the situation, sometimes taking a withdrawal from a 401K plan can be helpful. But you need to discuss your particular situation, run the numbers, and go through all the options with a specialist in financial matters.
Don’t let an inordinate fear of what bankruptcy relief has to offer, or a delusion about “preserving your credit” lead you into the costly mistake of losing your retirement.