Can't stay away from your 401(k) or IRA?

By MarketWatch

Talk about a downward spiral. Hundreds of thousands of Americans who have been pink-slipped recently are joining the millions already unemployed in figuring out how to make ends meet.

Yes, many might have severance packages, and some might have a few months' worth of living expenses set aside. But once severance packages and rainy-day funds are exhausted and unemployment benefits fail to cover daily living expenses, out-of-work Americans will likely raid the only piggy banks with any money left in them: their individual retirement accounts and 401(k)s.

Most Americans aren't dipping into those accounts to cover expenses just yet. Many are coping by reining in their spending, according to a Principal Financial Group survey released recently. And some are saving less, according to the 2008 Bank of America Retirement Savings Survey.

The Bank of America survey indicated that 18% of Americans had withdrawn retirement assets prematurely because of the recent economic turmoil. Many had raided those accounts to pay for near-term financial obligations, including credit card debt and mortgage payments. But more than one in five of those had withdrawn money early from their retirement funds because of recent job losses.

"If the economy continues to worsen, these numbers may increase significantly," Bank of America said in its release. "The possibility of many more Americans dipping into their retirement savings could have profound implications for the country's future economic well-being."

Funds of last resort

That kind of dipping would also have profound implications on your own immediate well-being. Craig Averill, a retirement-planning executive with Bank of America, suggests that retirement accounts should be viewed as funds of last resort.

Others agreed. "Taking a distribution from a retirement account is one of the least tax-efficient places from which to get the money," said Mark Nash, a co-author of PricewaterhouseCoopers' 2009 Guide to Tax and Financial Planning.

The distribution is subject to tax at ordinary rates, including state income taxes in most cases, plus a 10% penalty if you are under 59 1/2. What's more, Nash said, the added income could have a negative impact on other tax benefits that are phased out based on adjusted gross income.

Averill also noted that savers lose the power of tax-deferred compounding when taking a distribution from a retirement plan or a loan from a 401(k).

Given those ramifications, Averill and Nash recommended looking for money in just about any place other than an IRA or 401(k). Scour your expenses, searching for ways to trim fat. Borrow money from other sources, including your life insurance plan. Raid a taxable account. Even consider selling assets that produce a capital gain instead of ordinary income.

Tips from the experts

But if you must borrow or take a distribution from your IRA or 401(k), consider the following tips from the experts with regard to withdrawing money prematurely -- before age 59 1/2 -- from your retirement account:

1. IRAs and 60-day rollovers. You can avoid paying any ordinary income taxes and the 10% penalty by giving yourself a loan from a traditional IRA, provided you reinvest that money within 60 days in the same or another traditional IRA. You can also do a partial rollover and be taxed only on the amount that you don't roll back into the account. As always, check with a tax professional before trying this tactic.

2. IRAs and penalty-free distributions. You still have to pay the ordinary income tax due, but you can at least take a penalty-free distribution to pay for medical expenses that exceed 7.5% of adjusted gross income, as well as for qualified college expenses for you, your spouse or your children. First-time homebuyers can also take a penalty-free, one-time distribution of up to $10,000.

3. Substantially Equal Periodic Payment (SEPP) / 72(t) payments. According to Denise Appleby's Retirement Dictionary, you can also avoid the 10% penalty tax if you take a series of distributions from a qualified plan, 403(b) arrangement or IRA that are made in equal installment payments, over the life expectancy of the retirement account owner or the joint life expectancies of the account owner and his/her beneficiary.

4. 401(k) loans. If you're still employed and you need money, consider taking a loan from your 401(k). According to Bob Scharin, a senior tax analyst from the tax and accounting business of Thomson Reuters, the loan proceeds are not taxable, but they need to be repaid. What's more, "if your employment is terminated, whether because you chose to leave or were involuntarily terminated, the outstanding loan balance must be repaid immediately," he said. "Otherwise, that amount is treated as a distribution."

5. Hardship distributions from 401(k)s. Under certain circumstances you might be able to get a hardship distribution from your 401(k). According to the IRS, if a 401(k) plan provides for hardship distributions, it must provide the specific criteria used to make the determination of hardship. According to the IRS: "For a distribution from a 401(k) plan to be on account of hardship, it must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need."

Those expenses deemed to be immediate and heavy include certain medical expenses; costs relating to the purchase of a principal residence; tuition and related educational fees and expenses; payments necessary to prevent eviction from, or foreclosure on, a principal residence; burial or funeral expenses; and certain expenses for the repair of damage to the employee's principal residence. (Learn more at this IRS page.)

This article was reported by Robert Powell for MarketWatch.