New York – People hard up for cash – whether they’ve been set back by a job loss or a disaster such as Hurricane Katrina – may be tempted to tap their 401(k) accounts and other company-sponsored retirement plans. But this should be a last resort, not only because they face possible penalties but also because it undercuts their long- term security.
“This money is going to determine how you live in the long run,” said David Wray, president of the Profit Sharing/401(k) Council of America, based in Chicago. “So if you can deal with short-term emergencies out of short-term resources, that’s a better planning approach.” Better options for raising cash in an emergency include borrowing from relatives and friends, tapping a home equity line of credit or seeking a personal loan from a bank or credit union, experts say.
Company 401(k)s and other retirement accounts are inviting targets because in many cases they represent a worker’s biggest pool of savings, and most company plans allow for loans or “hardship” withdrawals. But because these accounts are funded with pretax income and grow tax-deferred, there are penalties if they’re tapped early – before a worker turns 59 1/2.
Wray said that if a retirement account is a desperate family’s only possible source of emergency cash, it first should consider borrowing, rather than withdrawing, from the account.
“You can borrow up to half the account balance or $50,000, whichever is less,” Wray said. “But if you borrow, you have to repay, typically through a payroll deduction.” Those payments are due at least quarterly, and they include interest, generally set at a percentage point over the prime rate, which currently is 6.5 percent. The interest goes back into the account.
If the worker terminates before the loan is repaid, it’s declared in default, and the worker will be required to pay federal and state income taxes on the unpaid balance plus a 10 percent penalty.
Workers who choose the other alternative, hardship withdrawals, won’t get nearly as much money as they hope. Companies withhold 20 percent of the amount withdrawn and forward it to the government to help cover the taxes. That amount, said Wray, probably won’t fully cover the taxes and the 10 percent penalty, so the worker will owe still more.
There have been proposals in Congress to waive the penalty and allow the taxes to be paid over several years if the withdrawals are used to reconstruct homes damaged or destroyed by Katrina, but it’s not yet clear whether they will be enacted.
Meanwhile, some Katrina victims will be eligible for grants from the Federal Emergency Management Agency, which is responsible for coordinating recovery activities, or from insurance policies that cover temporary living expenses when homes are damaged by storms.
But there are other alternatives for cash.
Stephen Brobeck, executive director of the nonprofit Consumer Federation of America in Washington, D.C., suggests families work on two fronts – raising money and calling on creditors to defer payments on bills.
“If you ask for understanding and relief from credit card companies and mortgage companies, the cash you raise will go farther,” Brobeck said.
He said families should seek loans from relatives and friends who are likely to be generous when there’s been a disaster.
Should you put the deal in writing? It depends on the family, Brobeck said.
“In some cases, a written agreement will make everyone feel more comfortable, especially the borrower,” he said. “But in other cases, the lender will feel insulted because they think of it as a gift, potentially.” Brobeck said piling debt on credit cards should also be a last resort.
“It could be very expensive, because cards typically carry rates of 17 to 18 percent, and that can kick up to 28 percent or higher if you’re late with a payment,” he said. Penalty interest of 28 percent on a $10,000 card balance can result in $2,800 in interest accumulating in just the first year.
Another way to raise cash is to tap assets, for example, by taking a loan against a life insurance policy or drawing on a home equity line of credit. These loans generally carry much lower rates than credit cards.
Jennifer Openshaw, chief executive of the Family Financial Network, a consumer education program based in Los Angeles, recommends families have home equity lines of credit in place – even if they don’t need them – so they can be tapped in emergencies.
Another possibility is asking parents or grandparents for an early inheritance, Openshaw said. People can give up to $11,000 a year to each of their children and grandchildren without triggering any gift tax, she noted, and the gift reduces the size of their estate, potentially saving on estate taxes.
