401(k) hardship withdrawals on the rise
By Laura Bruce • Bankrate.com

Cash-strapped employees are turning to their retirement plans as the credit crunch drags on and costs for everyday necessities continue their upward spiral. While hardship withdrawals from 401(k) plans are taken by a very small number of participants -- about 1.5 percent at Vanguard -- the giant fund company says hardship withdrawals have been increasing significantly; up about 17 percent in 2006 and another 9 percent in 2007.

"We would say from our data that the big uptick began earlier than the subprime crisis, which indicates to us that it wasn't a lagging indicator, it was a leading indicator," says Stephen Utkus, director of Vanguard's Center for Retirement Research. "When people started to have difficult times, they started tapping their 401(k) plan for various hardships and then, later, the subprime crisis manifested itself. We fully expected them to be up a little in 2006 and then really up in 2007 when, in fact, the big growth rate occurred in 2006. This suggests to us it's much more an issue of financially stretched households and not so much a subprime issue."

It's not hard to imagine that people who took on more mortgage debt than they could handle began looking to their retirement accounts to keep their heads above water.

Hewitt Associates tracks 1.5 million 401(k) participants at large corporations and says the trend for hardship withdrawals is continuing in 2008, and they don't expect to see that trend change throughout the rest of the year.

The number of loans from 401(k)s are holding pretty steady around 22 percent of participants at any given time, according to Pam Hess, director of retirement research at Hewitt.

"We did find that in 2007 and so far in 2008 the number of people initiating new loans is marginally higher, but they're shorter-term so they're paying them off quicker. But 22 percent of people with loans is a lot. That's always been one of our concerns. If it's a one-time thing and they really need the money and they're going to repay it in a couple years and they keep contributing to the plan so they get the company match, then some loans might be OK for a short-term solution."

IRS rules for withdrawals
Hardship withdrawals are allowed under IRS rules for "immediate and heavy financial need" that meets certain criteria.

6 IRS-approved hardships:

• Expenses for medical care previously incurred by the employee, the employee's spouse, or any dependents of the employee or necessary for these persons to obtain medical care. • Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments). • Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of post-secondary education for the employee, or the employee's spouse, children or dependents. • Payment necessary to prevent the eviction of the employee from the employee's principal residence or foreclosure on the mortgage on that residence. • Funeral expenses. • Certain expenses relating to the repair of damage to the employee's principal residence.

If the criteria are met, a hardship withdrawal can include the amount of the employee's elective deferrals. Employer contributions may be included depending on the company plan. Keep in mind that withdrawals are taxed as ordinary income; plus a 10 percent penalty.

You can't put the money back into your 401(k) once you get back on your feet -- and in most cases you're not permitted to contribute to your plan for six months after the withdrawal. That principal and the opportunity for compounding are lost forever and may have a significant impact on your retirement fund.