Raiding your 401(k) to Refinance

Clip from the Wall Street Journal – Tuesday, February 24, 2009

Raiding your 401(K) to Refinance

Mortgage brokers say that some of their clients are reaching into their retirement savings to “buy down” the principal on their mortgage in order to qualify for a lower-cost loan or because they don’t have enough equity in their home to refinance. While early withdrawals may be viable as a last resort, financial planners generally discourage them.

Here are answers to some questions homeowners should be asking.

Q: When are borrowers allowed to take money out of a 401(k) account to buy down a mortgage?

A: Only under narrow circumstances. Borrowers can’t take money out of their 401(k) unless they quality for a “hardship withdrawal,” as outlined in a company’s policy. For homeowners, Internal Revenue Service guidelines stipulate that such withdrawals can be made only for a first-time home purchase or to prevent foreclosure on a principal residence. While the IRS doesn’t set a maximum withdrawal limit, companies generally won’t allow employees to take out more than is absolutely needed to stave off an emergency.

That means that borrowers looking to withdraw in order to refinance would have to demonstrate that without the money, they would go into foreclosure.

“It is truly be a last resort,” says Dean Kohmann, vice president of 401(k) plan services at Charles Schwab Corp.

Q: What are the costs of an early withdrawal?

A: Borrowers must pay taxes on early withdrawals from either a 401(k) or an individual retirement account, and borrowers younger than 59 ½ usually must pay a 10% penalty. If borrowers withdraw from a 401(k), they must wait six months before they can begin contributing to their 401(k) again.

Q: Are there alternatives to taking an early withdrawal?

A: Yes, Many companies allow employees to borrow from a 401(k). Those loans are limited to half the value of the account up to $50,000, and loans generally have to be repaid within five years with interest. One big risk: If the borrower leaves the company, the loan must be repaid to avoid owing taxes.

If a homeowner must borrow from a 401(k) account to refinance a mortgage, the decision should be “part of a well-though-out plan as opposed to a quick fix,” say Mr. Kohmann.

Loans or withdrawals shouldn’t merely postpone a foreclosure for a few months and remember: 401(k) accounts can’t be touched by creditors in the event of a bankruptcy-which means that borrowing money from such an account may cause you to forfeit protection.