Workplace retirement plans exist to provide an income to draw upon when you are no longer employed. Over the years Congress has enacted some pretty good incentives by the way of tax breaks to encourage folks to participate. Long-term participation has huge benefits in providing a more secure retirement in your later years. With that going for you, don’t make a million dollar mistake with it.
In today’s post I’ll discuss why taking a Hardship Distribution from your retirement plan at work is not a good long-term solution for most people. Granted, most folks don’t take these lightly and those that do are usually facing a bad financial situation. However, I’ve seen some employees over my career use these distributions routinely rather than address the root cause of their financial issues.
Hardship Distributions
Generally speaking, hardship distributions can be available for any of six reasons. Below are the six reasons outlined by the IRS:
Under a “safe harbor” in IRS regulations, an employee is automatically considered to have an immediate and heavy financial need if the distribution is for any of these:
– Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
– Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
– Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
– Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
– Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
– Certain expenses to repair damage to the employee’s principal residence.
When taking a hardship distribution from a retirement plan there are two associated costs. The first is the initial tax obligation on the withdrawal. The second and more serious is the long-term opportunity costs.
Taxes can be cruel
One of the first issues participants face is the additional tax burden. The amount of the distribution is subject to state and federal income tax. Depending on other income and the size of distribution, it could place someone in a higher federal tax bracket. Moving from the 12% federal bracket to the 22% bracket can have a significant impact.
Then there is the 10% early withdrawal penalty. That penalty may be applied differently between IRAs and employer retirement plans. Hardship distributions from an employer 401(k) plan can be subject to the penalty tax. For a more detailed table of the tax on distributions, check out this IRS page.
To highlight an example, let’s assume Bob, a 32-year-old has a $100,000 balance in their 401(k) plan. Bob requests a $20,000 hardship distribution at the end of the year for the purchase of a primary residence. Bob only ends up with $13k (assuming an average 25% state and federal income tax plus the 10% penalty) to apply to the down payment for the house. Right off the bat he’s lost $7k to taxes. Bob only has 65% of the amount he needed because the government collected the other 35%. That’s a huge difference. You would never consider borrowing money from a bank that would charge you 35%! Not all of the taxes are withheld and many folks don’t realize the total size of the tax obligation until the following spring when they prepare their taxes. This can sometimes create another financial crisis.
The opportunity cost is worse
Worse still is the opportunity cost of that $20k. Using the same example, one could easily rationalize that Bob at 32 is young and has plenty of time to make up any disadvantage. But that’s usually not the case. The withdrawal in our example is 20% of the balance and that will project going forward. Why? Because it’s highly unlikely Bob or any other participant will ever rachet up contributions going forward to make up the difference. Let’s be realistic, if you’re taking a hardship distribution, you don’t have extra money laying around.
To demonstrate the impact of the long-term opportunity costs, see the tables below. I’ve simplified the models by not including future contributions. Future contributions would affect the models proportionately. For both models I am using a simple 8% annual return. Table A, “Ed”, is also a 32-year-old. Ed leaves his account to grow and does not take a hardship withdrawal at the end of the first year. Table B, “Bob”, takes a $20,000 hardship withdrawal at the end of the first year. Both started the year with $100,000 in their respective accounts.
The long-term problems
I’ll highlight several of the disadvantages to Bob when he retires at 62. First, his balance is off compared with Ed’s account balance by nearly 20% ($1,006,266 vs $819,920). The second disadvantage translates into less income at retirement. Using the “4%” rule, Ed can withdrawal $40,251 each year while Bob can only withdraw $32,797. That’s nearly a 23% reduction in retirement income. Over time, the withdrawals will have larger and larger dollar disparities. At age 82, Ed receives $72,697 each year while Bob receives only $59,235. Both tables inflate the initial 4% withdrawal by 3% each year.
I terminate my models at age 92 when Ed has a balance close to $4.0 million and Bob has a balance of $3.2 million. That too is a variance of nearly 20%. It’s a similar variance to when the participant took the hardship distribution 60 years ago. There’s a $736,874 account balance variance at age 92 between the two. That’s the difference of growth compounding the full $20k over a lifetime.
We can then add up the total distributions each received after 30 years of retirement. Ed received cumulative distributions of over $2.0 million to supplement his retirement. Bob on the other hand was again at that nearly 20% disadvantage with $1.6 million. A cumulative $372,711 variance.
It’s a Million Dollar mistake!
So, there’s the $1,000,000 impact. A $20,000 hardship distribution out of a $100,000 account at age 32 can have a million-dollar impact on retirement. $372,711 less in spendable income while retired and $736,874 less in the account pass onto heirs. That’s the million dollar mistake.
This is the impact of just one withdrawal of retirement savings. Over my career, I’ve witnessed employees doing it multiple times. For instance, over four years to pay tuition for their child to go to college. Rather than finding alternative ways to finance the education, these withdrawals are devastating the employee’s long-term financial future.
Think about the long-term impact
Certainly, most people, like Bob in the example above, have no idea a $20k hardship can have such an impact on their futures. The urgency of settling the current financial hardship can influence one’s thinking. Tapping into one’s retirement account may be an easy way to address an existing issue but creates others that are not obvious at the time.
In an earlier post, we covered the topic of the cost of waiting. There’s a similarity here. If you remove money from your retirement plan, it’s as if you’re wiping out years of savings and starting over at a later age. The cost of doing this is multiples of funds you actually get to use now.
Whether you are young or old, think about these long-term consequences. If you are thinking of withdrawing funds from your retirement account take a moment to figure out the long-term impact. It could be a $1,000,000 mistake.
I’d be interested in your thoughts. Let me know what you think.
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