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Should You Borrow From Your 401(k) in the Event of a Disaster?

By Katie Brockman - Oct 1, 2017 at 7:46AM

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Experts say you should never borrow from your 401(k). But recent hurricanes hitting the U.S. have changed the rules for some.

Hurricanes Harvey and Irma have caused major destruction, and it's taking a toll on the wallets of those affected. Roughly 80% of the victims of Harvey don't have flood insurance to cover the damage to their homes and belongings, and the damage from Harvey alone is estimated to cost up to $190 billion. That money has to come from somewhere.

Typically, financial experts advise against borrowing from your retirement savings to cover expenses -- even in the case of an emergency. But the rules change when it comes to extreme disasters, such as hurricanes.

After Harvey and Irma affected millions of people and left thousands homeless, the IRS relaxed its rules on 401(k) loans and withdrawals to make it easier for these people to get their lives back on track after the hurricane.

An envelope with cash inside and "401(k)" written on the side.

Image source: Getty Images.

Reading the fine print

Anyone who was affected by flooding or hurricane damage (or families of those who were affected) can take out loans or hardship withdrawals more quickly and easily than before, helping victims get cash faster.  The regulations surrounding what defines a hardship were also loosened, and now hurricane victims can withdraw money to cover things like food and shelter. The IRS also announced there would be a "minimum of red tape" when obtaining a loan or making hardship withdrawals, which also makes the process easier. Note, though, that any hardship withdrawals must be made by Jan. 31, 2018.

This doesn't mean that there aren't drawbacks to taking 401(k) loans or withdrawals. If you take a loan, you'll still need to repay it with interest within five years, just as you would in a non-disaster situation, and you can still only take up to $50,000 or half of what's in your account (whichever is less). Withdrawals are still subject to the 10% early withdrawal fee, and the money is added to your gross income for the year -- so you'll need to pay income tax on it (unless you have a Roth 401(k), in which case you've already paid taxes on that money).

The pros of utilizing your 401(k) when disaster strikes

Most financial advisors would probably tell you that you should never take money from your 401(k), but if you need it, you need it. That money doesn't do much good if you don't have a home or can't afford to feed your family. And while you may be eligible for government assistance, it potentially won't cover all your costs, and could take weeks or months to arrive.

In some scenarios, you have no choice but to take a loan or withdrawal after a disaster. If that's the case, start small. Don't immediately cash out and pull every dollar you've saved (unless you absolutely, truly need every last dollar).

If you expect your situation will improve relatively soon, it's usually best to take a loan rather than a withdrawal. You'll still have to pay that money back, but if you get back on your feet within five years, you can get your retirement savings back on track too.

For example, say you have $50,000 in your 401(k) and you take a loan of $10,000 that you repay in five years. Assuming an interest rate of 4% per year, after five years, you'll have repaid about $12,167. While it's not as much as you could have earned had you not taken the loan since there is a smaller amount in your 401(k) earning compound interest, you're still technically earning money as you repay that debt. If you withdraw that money, however, there's no requirement that you repay it -- which means it's easier to get off track and never recuperate those losses.

The downsides to loans and withdrawals

The biggest disadvantage to taking money from your 401(k) is that it throws your retirement off track. Depending on how much you borrow or withdraw, it can be difficult to recover.

Let's look at two different scenarios to see how much of a dent even a small withdrawal can make on your long-term retirement savings. Say you have $50,000 in your 401(k), and you withdraw $10,000. For simplicity's sake, let's also say you're not making any additional contributions in either scenario and that the annual rate of return is 7%.

Here's what your savings will look like in each scenario in five, 10, and 20 years:

Years Without Withdrawing With Withdrawing
0 (Today) $50,000 $40,000
5 $70,128 $56,102
10 $98,358 $78,686
20 $193,484 $154,787

After 20 years, that $10,000 withdrawal could end up costing you nearly $40,000. If you have no choice but to borrow or withdraw, you'll just have to suck it up and take the loss. But first, research your other options.

Check out government resources to see if you qualify for federal assistance. Keep in mind, though, that after any natural disaster that affects thousands of people, it will take a while before you receive any money. FEMA reportedly received over 760,000 applications from Texas residents alone, and it could take at least a month before they're approved for financial assistance.

It's also not a bad idea to reach out to friends and family after any type of disaster. They may be able to at least give you a place to stay while you wait for government financial assistance to arrive.

Nobody wants to think about what they'll do during a disaster, but after Harvey and Irma, that nightmare has become a reality for millions of people. While borrowing or withdrawing from your 401(k) will be a necessity for some people, check out other options first so that your retirement savings don't fall too far off track.

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