Money is saved in retirement plans in the hope that one day you will use it for retirement bliss. Unfortunately, advanced illness may hit unexpectedly and result in an immediate cash need. What do you do if you lack liquid assets but have money wrapped up in retirement plans? Fortunately, retirement plans can be used for advanced illness in certain situations. This article explains how to tap into your retirement plans during this difficult time in your life.
Step 1: Know what type of retirement account you have available
- 401k and 403b plans are very common and have similar rules. Your employer decides whether to allow hardship distributions when the plan is set up. Refer to the “summary plan description” that is provided to you each year or ask your human resource department if hardship distributions are available. For these plans, the IRS requires that you access all other available distributions and loans from the plan first.
- 457b plans have a slightly stricter definition of when plans can be utilized for illness. Distributions are allowed only when a participant has an unforeseeable emergency, so a sudden diagnosis of a serious illness would fit that category. The employer has to prove that you have no other resources in place to meet your need, so they will ask for appropriate documentation from you. Again, your employer has the ability to determine whether they allow hardship withdrawals in the first place, so check with your human resources department.
- IRA accounts can be used without penalty if you are older than 59 ½. If you are younger, there are three ways IRA accounts can be used for illness:
- If disability is “total and permanent” as determined by a physician, and you cannot work for at least a year, or the condition will result in your death, you are allowed to use money from your IRA penalty free.
- If you have unreimbursed medical expenses above 10% of your adjusted gross income, you can pay for those medical expenses out of your IRA account. Have an accountant or financial planner run calculations for you.
- If you are unemployed and drawing unemployment benefits, your IRA can be used to pay for health insurance premiums for you and your family.
Step 2: Understand the tax implication of the withdrawal
All withdrawals from 401k, 403b, 457b, and traditional IRA accounts are taxed as regular income upon withdrawal. Have an accountant or financial planner provide tax projections to prepare you for the tax consequences. Make certain you withhold enough taxes so you will not be subject to underpayment penalties.
Remember that the more you withdraw from retirement accounts, the higher your adjusted gross income will be on your tax return. This increase in income may limit your ability to deduct some health expenses. Likewise, if you have no income other than from retirement plans, taking distributions will create income that medical expenses can be deducted against in the tax year. Again, it would be wise to get an accountant involved early.
Roth IRA accounts are funded with post-tax dollars, so if you take early withdrawals, the amount you deposited originally (the basis) is tax-free, but any earnings are taxed at regular income tax rates.
Step 3: Apply for the withdrawal
Make certain the withdrawal paperwork from your place of employment states the withdrawal is for hardship purposes. If making a withdrawal from your IRA account, instruct the custodian of your account that the withdrawal is for hardship purposes – either for medical expenses or for permanent disability.
Because of the distribution, you will receive a 1099-R for tax purposes in January. Check this document immediately to make certain the distribution is coded correctly. Box 7 of the 1099-R should be marked with code 2 – early distribution, exception applies (under age 59 ½) or code 3 – disability. If the code is not correct, contact the custodian immediately and have them issue a new 1099-R with the correct code. If not corrected, the IRS will charge you a 10% penalty for the withdrawal.