Managing Money : Hardship Withdrawals Made Harder by IRS

If you wanted to give an award for the Greatest Employee Benefit, a lot of votes would go to 401(k) retirement savings plans. But new rules issued this month by the Internal Revenue Service make these fast-growing plans somewhat less appealing, particularly if you ever need to withdraw funds because of a cash crunch.

The plans are so popular because they allow you to contribute part of your pay into a fund that accumulates earnings tax-deferred until withdrawn, usually when you leave the firm or retire. Better yet, many companies will match your contribution by 50% or even 100%, thus as much as doubling your money right off the bat.

With such great benefits, the plans have taken off in recent years among large companies. While only about one in 20 companies of all sizes have them, about nine in 10 Fortune 500-size companies offer them, up from only four in 10 back in 1983, according to a survey by Hewitt Associates, an employee benefits consulting firm. Experts say the plans are far superior to the better-known individual retirement accounts.

But some employees facing financial emergencies have sought to withdraw money from their 401(k)s before leaving their firms. The IRS has allowed such withdrawals for “hardship” reasons, generally requiring that you pay a 10% penalty as well as taxes on before-tax contributions. But the agency never specifically stated what those hardships were, leaving that interpretation up to the discretion of individual companies.

Finally, after years of anticipation, the new IRS hardship-withdrawal rules--issued about a week ago as part of a series of new rules governing 401(k) plans--specify four types of hardships that companies may allow:

- Purchase of a primary residence. However, this cannot be for routine monthly mortgage payments, and excludes homes bought for family members other than yourself.

- Tuition expenses for you, your spouse or children. This must cover costs only for the next semester or quarter, and only for post-secondary education, such as in a college, university or vocational school. Costs for private high schools don’t count.

- Medical expenses incurred by you, your spouse or dependents.

- Payments to prevent eviction from your primary residence, or foreclosure on your mortgage.

The four above categories are about what many employers were allowing anyway. And the IRS also left room for employers to add other hardship criteria, as long as the criteria are applied evenly to all employees, an IRS official says.

Thus, some employers might also allow early withdrawals for such hardships as unusually high divorce or legal settlements, or loss of your spouse’s job. (On the other hand, employers don’t have to include all of above criteria and can even bar withdrawals under any circumstances, the IRS official says.)

But the new rules go much further. They include a new provision that requires you to show to your employer that you made reasonable attempts to obtain money elsewhere. That includes seeking loans from commercial lenders as well as from your 401(k) itself. Nearly two of three companies now allow 401(k) loans, Hewitt Associates estimates.

You also must show your employer that you sold assets owned by you or your immediate family that did not create a financial hardship when sold. That would include non-essential items, such as pleasure boats, vacation homes, fur coats or collectibles but not your primary home or car.

“It never before was this stringent,” says Howard C. Weizmann, executive director of the Washington-based Assn. of Private Pension & Welfare Plans. “There never was a requirement that you must demonstrate that you sold assets.”

That’s not all. Yet another major new restriction requires that after you take an early withdrawal, you must wait 12 months before you can contribute again to your 401(k).

Still another restriction limits what you can put into your 401(k) the year after a withdrawal. That limit is equal to the maximum amount allowable for anybody to contribute per year under any conditions--now set at $7,313--minus the amount you put in the year you made the withdrawal.

So, for example, if you make a withdrawal this year but also contribute $5,000, you can only put in $2,313 next year (presuming the annual limit stays at $7,313, which is unlikely. The limit rises each year based on a formula tied to inflation.).

This last restriction shouldn’t hurt most lower- or middle-income workers, since their annual contributions rarely exceed $3,000 to $4,000 anyway, says Karen L. Frost, consultant with Hewitt Associates. But for higher-income executives, it could be major blow that would discourage them from withdrawing from 401(k)s, she says.

The thinking of the IRS is clear. “We just don’t want people playing games with 401(k)s. Withdrawals were intended for legitimate hardships,” says an IRS official, adding that “Congress intended people to use 401(k)s to save up for retirement.”

“They want to make you think twice about withdrawing, but instead they will make you think three, five, eight times,” Weizmann says.

But by making it a lot harder to withdraw funds, Weizmann contends, these new rules--by adding an administrative burden--may prompt some companies to stop allowing withdrawals at all, which is their prerogative. “The employer may begin to think twice” about allowing withdrawals,” Weizmann says. “The plans are already too complicated.”

Others say that with reduced access to your money, you may not want to contribute at all to a 401(k) this year if your company does not provide any matching contribution. That is also because individual tax rates this year may be the lowest in years, so it may be better to get taxed on income now at low rates than get taxed on it later at higher rates.

“Without a good-sized company match, you’ve got to think twice about putting money in in the first place,” says David A. Berenson, national director of tax policy and practice for the accounting firm of Ernst & Whinney.

Wiezmann adds that by eroding the popularity of these plans--particularly among lower-income people who are most likely to want easy access to their savings--the IRS could be undermining political support for 401(k)s. Already, he says, Congress is considering placing further restrictions on them--as it did in the Tax Reform Act of 1986--to raise more tax revenue.

Bill Sing welcomes readers’ comments but regrets that he cannot respond individually to most letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.