With the changes in lending that have occurred recently there are some lenders out there who are farming their contacts encouraging people to buy homes and get the minimal down payments necessary by withdrawing money from their retirement accounts under the "hardship allowance" some retirement plans offer. When someone reccomends this they sell it as you're just, "borrowing from yourself" and you are paying back yourself with interest. It's great to be your own bank isn't it? Well maybe and maybe not...
1. Under what circumstances can a participant get a hardship distribution from a retirement plan?
A retirement plan may, but is not required to, provide for hardship distributions. Many plans that provide for elective deferrals provide for hardship distributions. Thus, 401(k) plans, 403(b) plans, and 457(b) plans may permit hardship distributions.
If a 401(k) plan provides for hardship distributions, it must provide the specific criteria used to make the determination of hardship. Thus, for example, a plan may provide that a distribution can be made only for medical or funeral expenses, but not for the purchase of a principal residence or for payment of tuition and education expenses. In determining the existence of a need and of the amount necessary to meet the need, the plan must specify and apply nondiscriminatory and objective standards.
(Reg. §1.401(k)-1(d)(3)(i))
If your 401(k) plan made hardship distributions that didn’t follow the plan language, or if your plan doesn’t have hardship language, find out how you can correct this mistake.
The rules for hardship distributions from 403(b) plans are similar to those for hardship distributions from 401(k) plans.
If a 457(b) plan provides for hardship distributions, it must contain specific language defining what constitutes a distribution on account of an "unforeseeable emergency."
(Reg. § 1.457-6(c)(2))
In other words your specific plan MAY or MAY NOT allow a hardship distribution, it all depends on the regulations of the specific plan from your employer. It's important to check the documentation for your individual plan. So if your plan offers this feature then it's a great thing right? Well also consider this from the same IRS FAQ site:
5. What are the consequences of taking a hardship distribution of elective contributions from a 401(k) plan?
After an employee receives a hardship distribution of elective contributions from his or her 401(k) plan, generally the employee will be prohibited from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least 6 months after receipt of the hardship distribution. (Reg. §1.401(k)-1(d)(3)(iv)(E)(2))
Hardship distributions are includible in gross income unless they consist of designated Roth contributions. In addition, they may be subject to an additional tax on early distributions of elective contributions. Unlike loans, hardship distributions are not repaid to the plan. Thus, a hardship distribution permanently reduces the employee's account balance under the plan.
A hardship distribution cannot be rolled over into an IRA or another qualified plan.
(Code § 402(c)(4))
So once you take a hardship distribution you cannot make any contributions into that plan, or any other retirement plan, for six months or until the distribution is repaid, which ever is later. Your retirement savings is now put on hold for a minimum of six months. Not as sweet of a plan any more is it? There's one more thing to seriously consider when looking at this option to get the money you need to purchase a home...
Since each plan is governed by individual employer the account must be made whole before you leave that employer, otherwise the hardship distribution, aka loan, must be repaid before you leave. Leaving your employment can be either voluntary - leaving for a new or better paying job, or leaving involuntarily - being fired, down sized, or location closure. If the loan is not repaid before you leave your employer it is treated as an unqualified distribution, added to your annual income and then subject to your normal income tax rate plus a 10% penality.
To avoid this issue you will need to pay back the loan before you leave which ofen means borrowing from somewhere else - a personal loan, home equity loan, friend/family member loan, etc. Can you start to see the downward spiral you can get yourself into?
"Borrowing from yourself" isn't sounding so rosey any more is it? Please confirm all this with your local tax professional, but I want you to have the information to ask the right questions when you are considering using these special provisions. It's likely better to consider other avenues to get the funds you need to buy that deam home and not turn it into a nightmare.
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