Just like time, interest rates wait for no man. When rates dip low enough to make it cost-effective to refinance your home, it may be time to jump on the opportunity and scrape up the down payment for a refi. Although your 401k balance may be a tempting place to turn to find the capital, don't think that your fund's hardship distribution rules are going to make it easy for you, or allow you at all, to qualify for an early distribution to help with your refinance.
401k Early Distribution Rules
The Internal Revenue Service allows 401k plan administrators leeway to determine when employees can tap into their retirement account. Because of this, you may not be able to make a hardship distribution for your refinancing at all. Check with your company’s plan administrator to get the skinny on the details that govern your plan’s guidelines. Don’t hold out too much hope for a hardship distribution, though. The IRS only allows real-estate related hardship distributions from retirement plans when they’re made to stave off foreclosure or eviction, so you’ll need to show you’re taking the funds to keep yourself off the street, not just to lower your monthly payments.
Tax Implications of Hardship Distributions
If you do qualify for a hardship distribution to help fund your refi, brace yourself to take a big hit from the tax man. Unless you contribute to a Roth 401k plan you make pre-tax contributions to the fund, which, accountant-speak aside, means you’ll need to pay income taxes at your normal rate on the full amount of the distribution. If you’re in the 25 percent bracket and need $10,000, you’ll need to withdraw about $13,200 to cover taxes on the distribution – $2,500 for taxes on the $10,000 and another $625 or so to cover the taxes on the $2,500 additional distribution.
Limitations on Funds Available
Even if your plan’s hardship distribution rules and the IRS regulations on hardships allow you to use money from your 401k to refi your house, don’t count on being able to drain the account to pour equity into your home. The IRS only allows investors to withdraw the elective contributions you made to your account – those you specifically authorized to be withheld from your paycheck. Funds that come from earnings, contributions made in your behalf using your company’s money. You may need to check with your plan advisor to determine how much of your retirement balance may even be available for a hardship distribution.
Many plans allow members to make short-term temporary loans to themselves using funds in their 401k. As with hardship distribution rules, the regulations that govern these loans vary between plans, though the IRS will only allow you to borrow $50,000 or half of your account’s balance, whichever is smaller. Therefore, a 401k loan might not help if you have a small account balance or need to refinance a mansion. You’ll dodge the taxes that come with premature distributions, and are only charged interest on the loan. Because you’re technically loaning the money to yourself, that interest goes straight into your account. If you lose your job or find a better place to work, you’ll need to repay that loan on the spot. In addition, if you cannot cover your tab, the IRS treats it as an early distribution, and you’re on the hook for income taxes and early distribution penalties.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.