Borrowing from your retirement plan may avert foreclosure, but be aware of risks

October 14, 2011

With hundreds of thousands of homeowners facing imminent foreclosure and estimates of 2 million or more in the wings, are there any financial tools available to distressed borrowers that haven’t been tried yet? Equally important politically: Is there a way to help owners that won’t rack up huge federal expenditures and add to the deficit?

The Obama administration has been exploring options — including a new refinancing program expected later this month — but a concept has surfaced on Capitol Hill that might offer modest help with no revenue cost to the government: Amend the tax code to allow homeowners who have 401(k) retirement plans to pull out money to save their houses from foreclosure without the usual tax penalties.

The change would work like this: Under current rules, anyone making what’s known as a “hardship” early withdrawal from their 401(k) must pay the IRS a 10 percent penalty on top of ordinary income taxes. A bill introduced Oct. 5 would waive the penalty if the purpose of the distribution is to make loan payments to avoid loss of a primary home to foreclosure.

Co-authored by Sen. Johnny Isakson and Rep. Tom Graves, both Republicans from Georgia, the bill would allow owners to pull out up to $50,000. The money could be used in a lump sum to pay down the delinquent mortgage balance or to fill shortfalls caused by reductions of household income. It could also be used as part of loan modification agreements with lenders designed to avert a foreclosure. However the money is used to resolve the mortgage delinquency, it would need to be spent within 120 days of receipt and could not exceed 50 percent of the funds in the retirement account.

Owners would be subject to income taxes on the amounts withdrawn, but they would escape the penalty. Though neither of the co-sponsors claims the bill would actually raise revenues — they simply say it won’t cost the government anything — some pension program experts say it might.

Ed Ferrigno, vice president for Washington affairs at the Plan Sponsor Council of America, a group that represents employers that offer 401(k) accounts to workers, said that by triggering taxable distributions from otherwise untouched, tax-deferred plans, the bill “should generate revenues.” Ferrigno declined to comment on the bill overall, pending further review of its provisions.

Titled the HOME Act, the proposal sheds light on the potential foreclosure-avoidance benefits — and drawbacks — of tapping employee pension accounts.

Many, but not all, 401(k) plans allow for loans to participants, including for housing-related purposes. Retirement advisers generally recommend taking a loan from a plan rather than a withdrawal because the money is then not taxed or penalized. And the federal tax code sometimes requires a loan rather than a withdrawal. Borrowers are required to pay interest on the loan, but in effect they are paying it to themselves to offset the earnings forgone on the funds taken out.

The Internal Revenue Code limits hardship distributions to situations where there is an immediate and urgent financial need and there are no other funds available to meet this need.

For those who cannot borrow against their retirement plans, the 10 percent penalty discourages potential users, Isakson and Graves argue. Their bill would remove that disincentive and provide an emergency escape hatch for owners sliding fast toward foreclosure.

Putting aside the potential positives, are there downsides to making a hardship withdrawal from your 401(k), even penalty-free? You bet. Pulling out 401(k) dollars early — with or without a tax penalty — is an expensive way to raise money. Not only does it deplete the tax-deferred savings you’ve set aside, but in the case of hardship withdrawals, you are prohibited by IRS rules from making new contributions to your plan for six months.

Even if the HOME bill makes it through Congress — and there’s no assurance it will — taking the hardship route should never be your first choice. It should be your last resort, when there’s nothing else that will save your house and you don’t want to walk away.

However, also consider the pension plan alternative that may already be buried away in your plan documents: a save-the-house loan to yourself. If the numbers work and you have a reasonable chance of avoiding foreclosure and repaying the loan, check it out.

It just might be your solution.

Harney’s e-mail address is kenharney@earthlink.net.

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