Obama's Broken Promise? 401(k) Penalties Persist

In these tough times, it's natural that many individuals are looking to their retirement savings as a source to meet pressing needs.

A 401(k) plan or similar retirement account is the single largest asset that many Americans have, after their home. It seems like the best place to turn in times of financial hardship, but be aware that such a move comes at a cost.

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IRS rules about tapping a 401(k) account before retirement are strict and provide limited exceptions to allow you to gain early access to your money. Even if you qualify for an exception, there's a good chance you will still be subject to a penalty on top of the usual income taxes.

The question below comes from a reader who wonders whether she might be able to tap into her 401(k) account to meet current needs.

Q: I thought I read somewhere that if you were laid off and had to withdraw from your 401(k), the government would not fine you the extra 10 percent for early withdrawal. But when I went to my accountant to do my taxes, he was not aware of this. Is it true or not?

-- M.H., Southfield, Mich.

A: M.H., your accountant is correct. There currently is no provision to allow you to withdraw 401(k) funds early without penalty in the event of a layoff.

Late in the 2008 campaign, President Obama proposed allowing penalty-free withdrawals of up to $10,000 from 401(k) accounts and other retirement savings plans in response to the current recession.

Thus far, this is one campaign promise that has gone nowhere. There was no such provision in the recently enacted economic stimulus plan.

In most cases, a hardship withdrawal from a 401(k) or other retirement savings account before age 59½ will still trigger a 10 percent penalty plus federal, state and local income taxes.

Take a $10,000 early withdrawal from a retirement plan, and you could easily lose 40 percent to taxes and penalties, depending upon your tax bracket and where you live. That's why an early withdrawal should be an absolute last resort.

How Hardship Withdrawals Work

Under current law, employers have the option of allowing hardship withdrawals by participants in the event of what the IRS calls "an immediate and heavy financial need." Eligible expenses include medical care, costs related to purchase of a home, education payments, funeral costs and payments to prevent eviction or foreclosure.

Even if those conditions are met, you must show you have no other financial resources to cover those needs. For example, if you own a vacation home, the IRS considers that a resource that can be used to help cover the expense, and therefore, you do not qualify for a hardship withdrawal.

Two additional points to keep in mind about hardship withdrawals:

First, they are available at the employer's option, meaning even if you're willing to pay all the taxes and penalties, you still may not be able to obtain one.

Second, even if your employer allows them and you qualify, the 10 percent penalty remains in place.

There is a long-standing provision in IRS rules that allows some older, laid off workers to withdraw from their 401(k) accounts or other employer-sponsored plans without incurring a penalty.

This provision permits employees who leave a company in the year they turn 55 or later to make penalty-free withdrawals from a 401(k) or other qualified retirement plan. If they leave before then -- say at age 53 -- they can't wait until age 55 and then begin withdrawing.

The "separation from service," as the IRS puts it, must occur at age 55 or over, or in the calendar year you turn 55. For public safety workers, the age threshold under this provision is 50.

For older, laid-off workers who would qualify, this could be a reason to keep your retirement funds parked in the 401(k) account rather than moving them to an IRA.

For younger workers, however, moving the funds to an IRA might be the better option. With an IRA, there's no employer or hardship requirement to block an early withdrawal if you're willing to pay the 10 percent penalty.

Also, an IRA allows for penalty-free, early withdrawals in limited circumstances, such as covering higher education expenses and first-time home purchases.

Penalty-Free Withdrawals in the Future?

If you feel you must withdraw from your retirement accounts to survive the current turmoil, take a close look at IRS publications 575 and 590, which outline the various penalties and exceptions that pertain to IRA, 401(k) and other retirement accounts.

My advice is to avoid these moves if at possible, but I understand these are the toughest economic times many of us have ever lived through.

That's why I believe the longer the current economic turmoil lingers, the higher the likelihood that penalty-free withdrawals from retirement accounts will be allowed. There's recent precedent to think this might happen.

Over the past few years, Congress has approved special legislation that allowed such measures for military reservists called to active duty, and taxpayers affected by hurricanes Katrina, Rita and Wilma and tornadoes in Kansas and elsewhere in the Midwest.

For instance, homeowners and workers hurt by a series of tornadoes and storms that struck Kansas May 4, 2007, could withdraw up to $100,000 from retirement plans without penalty if it was done before the beginning of this year. Those distributions were still subject to income tax, but taxes could be spread out over a three-year period.

If the current economic storm lingers, don't be surprised if we see more of this coming out of Washington.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.