Hard Penalties on Hardship 401(k) Withdrawals

Q: Now that interest rates have fallen so dramatically, I can finally afford to take on a monthly mortgage. Now, the only thing holding me back from buying my first home is coming up with a big enough down payment. I belong to a 401(k) plan at work. May I make a hardship withdrawal from that account to get the money I need? --B.B.

A: Yes, you may make a hardship withdrawal from your 401(k) account, but after reading this you may not want to. In general, the government allows hardship withdrawals for medical expenses, the purchase of a principal residence, payment of college tuition for spouses or children and payment of a household rent or mortgage where eviction or foreclosure is threatened. Your company’s plan may accept additional hardship claims, such as funeral expenses, legal bills and loss of family income due to disability or a spouse’s layoff.

However, even if you have an accepted hardship case, taxpayers under age 59 1/2 who withdraw funds from their 401(k) plans are, with limited exceptions, automatically hit with a 10% federal penalty plus any applicable state penalty. (In California, the penalty rate is 2.5%.) Buying a new home, whether or not it’s your first-ever purchase, is not one of the penalty exceptions. So off the top, you would be forfeiting at least 12.5% of your savings to the government. (Hardships exempted from penalties include excessive medical bills and payments made to employees who leave their jobs after turning age 55.)

In addition to the penalties, you would be required to pay state and federal income taxes on the amount withdrawn. (Remember, you have been saving this money on a tax-deferred basis; the government will want its share as soon as you get your hands on it.) Assuming you are in the highest state and federal tax brackets, a $20,000 withdrawal from your 401(k) plan would net you about $10,700 toward your down payment. Is this really where you want your retirement savings to go?

Why not consider taking out a loan against your 401(k) account? Some companies allow their employees to borrow against their account totals, a tactic that avoids both the penalties and tax implications of a withdrawal. Check with your personnel or employee benefits office to see if your plan permits loans; not all plans do.

If you can’t get a loan--or are somehow still determined to make an early withdrawal--your first step should be to contact your employee benefits office to learn how your company handles hardship withdrawal applications. Be prepared to be told that your application could take as long as two or more months to process, a factor that could be critical in a home purchase. You should also expect to explain why you need the hardship withdrawal, to provide detailed family financial data and certify that you have no other financial resources to tap to cover this hardship.

Divorcing Strictly for Tax Convenience?

Q: In a recent column you said that a divorced husband and wife, both over age 55, would each be entitled to a $125,000 exemption upon the sale of their principal residence, providing that the house was sold after the divorce. As my wife and I will have a potentially large gain when we sell our home, would the Internal Revenue Service have any legal recourse if we would undergo a divorce of tax convenience? We are happily married but aren’t particularly anxious to give the government our money. --A.C.

A: Your proposal could be construed as fraud and as such is not legal. However, unless you left a paper trail detailing your intentions or remarried within months of your “divorce of tax convenience,” the likelihood is slim that the IRS could detect or prove any fraud.

But even if you could pull off your scheme with impunity, there are several reasons to question its true wisdom.

For example, are you prepared to give up the step-up in tax basis that assets held as community property are entitled to in exchange for the additional $125,000 exemption? If you have $250,000 of residential profits, you likely have other substantial assets.

What about your pensions and other retirement savings? Will they still have the same payout upon the death of one spouse to the survivor after a “divorce of tax convenience?” Finally, what will this divorce cost you to pull off? Surely, you and your wife can’t expect to continue living under the same roof--especially after selling your principal residence--and still argue that you are really divorced in name and spirit.

There are better ways than a “divorce of tax convenience” to cut your tax bite. Your local public library and book store are loaded with books and magazines offering plans that are both wise and honest.