Can you borrow from a 401(k) after a natural disaster?
Imagine it’s Wednesday afternoon and you’re on the downside of your work week. You’re looking forward to working in the yard, taking in a ballgame, or perhaps hitting the greens for a round of golf this coming weekend. Off in the Atlantic, a tropical storm is brewing but forecasters predict it will spin harmlessly off the coast, trailing back into the mid-Atlantic. By Friday, the forecast changes and the storm is bearing down on you. A disaster looks imminent, so what do you do?
Should you use your retirement account to fund natural disaster repairs?
First off, there are a few things you should not do. Number one is to tap your retirement account to repair and rebuild. Why? It’s your money and you need it now, after all! If you have few or no assets besides your residence, that may be the only option. But for those that have a choice, other financial resources should be considered before tapping into retirement savings. Here’s why.
If you take a plan loan to help with rebuilding, you will be repaying the loan back with after-tax money, including the interest you are paying yourself. Additionally, the borrowed money is no longer invested, which means you permanently lose the returns associated with the money you borrow while it is out of the plan. Finally, when you withdraw the repaid loan money in retirement, you will owe taxes again on the amount repaid, meaning you will essentially pay tax on the money twice. Once when you pay the loan back with after-tax dollars; again when you pay tax on the plan distribution.
Using retirement funds to pay for natural disaster costs
Say you need $6,500 to fix your hurricane-hit roof, so you take out a 5-year loan from your retirement plan at 5 percent interest. If you are paid every two weeks, your repayment will be $61.34 per paycheck. But because of your tax bracket, your income is taxed at 25 percent, meaning you’ll need to earn $81.79 before taxes to make this payment. Why, you ask? Because you are using after-tax money to repay the pre-tax money used in the loan.
Over the life of the loan in this example, you will need to earn about $9,700 in pre-tax money to pay off the loan principle and interest of $7,274.72. And this $7,274.72 is subject to tax a second time when it’s distributed from the plan.
If you instead decide to take a hardship distribution, the effect can be just as bad. Your distribution will be taxed as ordinary income, and if you are under the age of 59 ½, you will also owe a 10 percent early withdrawal penalty. Plus, you will lose the compounded returns the money could have earned over the years had it stayed in the plan, and if you’re in the 25 percent tax bracket, you’re only getting 65 cents on every dollar you pull out.
What? It works like this. If you take a $10,000 hardship from your plan, you would typically owe about 25 percent in tax ($2,500 in this example). Add in the 10 percent early withdrawal penalty of $1,000, and your $10,000 withdrawal is now only worth $6,500— or the cost of your roof repair.
As you can see from these examples, tapping a retirement plan should not be a first choice, or even second choice, for funding in a disaster. Another point to consider, depending on the state you live in, is that taking a retirement distribution may affect your eligibility for drawing unemployment if your employer is forced to lay you off due to the disaster.
If you have questions, we are here to help. PAi’s 401(k) services stay on top of current and pending legislation that may affect your 401(k) or your retirement goals, giving you more time to spend on what’s most important to you. Contact us online or give us a call today: 800.236.7400.
Kent Wright – Due Diligence and De-accumulation Analyst – email@example.com – 800.236.7400 Ext. 3252
Kent is a subject matter expert on 401(k), retirement accounts, investments, and financial services. Kent is also a published author.