Getting Emergency Money

But should you?

Your retirement savings plan lets you request a hardship withdrawal from your account balance after all other financial resources have been exhausted. Generally to be considered, you must present evidence of an "immediate and heavy financial needs" (contact your retirement vendor for specific requirements) for one of only four purposes allowed under present IRS guidelines. They are:

• Substantial uninsured medical expenses incurred by you or your dependents.

• Purchase of a primary residence. Includes down payment or earnest money, but not mortgage payments.

• Tuition payments for post-secondary education for you or your dependents.

• Prevention of eviction or foreclosure on a primary residence.

You may only withdraw an amount that meets your documented immediate need plus 20% extra for withholding tax. You may withdraw from your total employee contributions, but not any interest or investment income these contributions may have earned. Also, from the time of the withdrawal, you may not be permitted to make any employee contributions for 12 months.

The purpose of retirement savings plans is to finance retirement, not unexpected cash emergencies. Therefore, the school, as well as the US government, discourages you from thinking of your retirement savings as a cash resource before you retire. In exchange for saving for retirement, the US government allows you to invest your contributions (and other contributions that may apply) without paying income tax on them first. You also don’t have to pay taxes on any investment earnings, interest and dividends that these contributions generate until you begin withdrawing money from your account. This can enable accelerated growth of your investments because you have much more money going into your account and none coming out.

The problem

Nevertheless, most of us find ourselves needing large sums of cash once in awhile.  Considering your retirement savings plan account balance as an emergency cash source is natural and understandable, especially if the need is great and time is short. For most people. though, better sources exist. That’s why hardship withdrawals come with such severe limitations.

You may already have a better way to meet emergencies — even the ones allowed for hardship withdrawals. The best way of course, is to plan ahead when you aren’t facing an emergency.

What it costs you to withdraw

A hardship withdrawal will cost you a bundle in taxes now and in future wealth. Taxes eat a big chunk of a withdrawal. First, up to 20% of the withdrawal may be withheld For federal income tax; you’ll have to withdraw more than you actually need. Next, the IRS will add the total withdrawal to your annual income. And, if you withdraw money before age 59 ˝, you will likely owe a further tax penalty of 10% of the total withdrawal.

Plus, withdrawing money robs you later on in retirement when you’re even more vulnerable to unexpected cash outlays. Simply put, you’ll likely end up with a smaller nest egg. You may have a leaner retirement or have to retire later than you planned.

For example, suppose you withdraw $ 10,000. You plan to retire in 20 years and you’re 42 years old. The table below shows a typical scenario.

Consider a loan

If you’d taken a consumer loan at 8% for five years, the $10,000 would have cost you an additional $2,166 in interest compared to $3,800 dollars in taxes. You’d have to increase the interest rate by 50% or stretch the loan out more than nine years (at 8%) before a loan costs you more than the tax obligation on the withdrawal example above.

If you’ve exhausted all other avenues, hardship withdrawal may be your only recourse. However, all of us can do a little planning and thinking to create other avenues for emergencies in the future.

Some ideas

Most homeowners can usually borrow against the equity they have in their homes. The interest rate will normally be lower than a general-purpose loan,— closer to what you’re paying on your mortgage. Taking a home-equity loan also may enable you to declare the interest you pay back as a tax deduction. This effectively reduces your obligation since you get back some of what you are paying in reduced taxes. Contact your bank or credit union for more information on home-equity and other types of loans.

Some people may be able to borrow from family or relatives. The advantages may long outweigh the obligation and any embarrassment, especially if you foresee problems getting a loan from a financial institution.