If your family has a financial crisis and needs money in a hurry, you may be tempted to use personal assets that never were intended for emergencies. Consider the consequences before you do.
The crisis could be illness, a death in the family or divorce. For millions of Americans who are victims of the recession, the problem is unemployment.
When you've made all the obvious moves, such as cutting back on your living expenses, should you tap the equity in your home? For many families, this investment is their only major asset. A home equity loan would enable you to clean up debts and provide funds for living. It's enticing.
Your ardor may cool if you remember that a home equity loan really is a "second mortgage." If you are unable to make your mortgage payments promptly, your lender can foreclose and you have lost your home. Think it through before you take on any such additional debt during a crisis.
It will be equally tempting to look at funds you have set aside for retirement. You know that the money you have in an individual retirement account (IRA) or other retirement plan is meant to stay there. Taking that money out before you reach retirement age can cost you heavily in penalties and taxes. Yet, if you "borrow" these funds, you have some chance to control the penalties. To minimize your loss, be aware of some basic rules governing early withdrawals, say the editors of Bender's Federal Tax Service.
Here are answers by the Bender editors to questions frequently asked about early withdrawals and lump-sum distributions:
* If you take money from your IRA, you will be taxed and subject to 10 percent penalty, unless you have reached the age of 59 1/2 .
* When you take a distribution from an employer plan, you will pay tax, and the early 10 percent penalty charge applies. However, you may not be taxed on the full amount that has been accruing interest in your plan. Your personal after-tax contributions will not be taxed. Only interest and employer contributions are taxed.
* The same is true for non-deductible contributions to an IRA. The portion of the distribution attributable to non-deductible contributions will not be taxed.
* Don't overlook this great device! You can receive a distribution from an IRA and make a rollover contribution to another IRA only once during any one-year period. But you will not be taxed or penalized if you roll over the same property you received from your old IRA into a new one in 60 days. This ploy enables you to borrow money from yourself for an emergency without being penalized.
* You can avoid paying high taxes on money you roll over from retirement plans by making a partial rollover. If you receive a lump-sum distribution, you can keep part of it and roll over part of it, and you are taxed only on the part you keep.
* You may be able to borrow money against your employer's retirement plan. But bear in mind: loans are treated by the Internal Revenue Service as distributions unless they meet complicated requirements governing employer loans. Your employer is under no obligation to supply you with this service. Speak to your supervisor, a financial or personnel officer about it to find out if your company has the service.
* If you receive a lump-sum distribution from a plan because your spouse has died, that money will not be taxed if it is rolled over into an IRA. If you do not roll the money over, you will pay tax on it.
* If you are the beneficiary of a deceased employee or deceased former employee, you will pay taxes on the pension or annuity you get, but you also may be entitled to a death benefit exclusion, which is limited to $5,000.
* If you get an early distribution because of divorce, both husband and wife are taxed and early distribution penalties apply. You can avoid the problem if you roll the money over into your own IRA.