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What is the best way to use my 401k to help my parents with medical expenses?

I have a chunk of money sitting in a 401k from a previous job that I'd like to put to good use and help my parents pay for some unexpected medical bills. Should I:

A. Cash out the whole thing? B. Roll it over to the new company and only cash out a portion? C. Roll it over and take a loan? D. Options I'm not seeing?

Which option has the least fees + taxes?

I'm still young and have a lot of time left in my career to replace the money and the security and peace of mind is more important to me.

Feb 27, 2014 by Nicole from Los Angeles, CA in  |  Flag
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6 votes

Nicole, Your willingness to help your parents is admirable, but slow down and consider all options. First someone should be looking at your parents situation to determine what options are available to them. For instance, medical providers will often negotiate very generous long term payment plans with patients who have financial difficulties. What other options might be available? Would they qualify for a reverse mortgage perhaps? This is all speculating - since we don't know much about your parents situation.

What I do know is that your confidence in being able to rebuild your savings may be misplaced. Early contributions are key to building a successful nest egg.

Since it is an old employers plan, you have few attractive options. You can't take out a loan, because you are no longer working there. MAYBE you can roll into the new employers 401k and take out a loan - if there is a loan provision in the 401k that permits that. Loans are limited to 50% of the total value, and must be repaid within 5 years (immediately if you leave the employer). Taking a loan is the only way that you can get the money without sacrificing a huge chunk to the government.

If you withdraw the funds you will get slaughtered with tax. Say you make $50,000 and take out $20,000 from a retirement plan. Your income goes up to $70,000. That entire extra $20,000 is taxed at 25% marginal tax rate, so you are left with 15000. But you also need to pay a 10% penalty, so you are left with only $13000 of the $20,000. Very expensive money.

A loan from your CURRENT plan (after rollover if permitted) is your best choice, but I advise you to check out all alternatives first. I strongly advise against downplaying the importance of these early retirement savings.

View all 5 Comments   |  Flag   |  Feb 27, 2014 from Bridgewater, NJ

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5 votes

I understand your concern and your certainty that you can replace the money from your 401k.

One initial question is - will your parents have additional medical expenses that they can't cover and will you help them more in the future if they do have additional expenses? If the answer to this is yes, then the odds are that you will at some point start to use savings that you can't replace.

The other thing about being certain you can replace moneys used from retirement savings is really a slippery slope. You will be inclined to use retirement savings in the future whenever there is a crisis. You also can't know what challenges you may face in your work life going forward that may inhibit your ability to save for retirement.

So, I believe my best advice on the initial issue is to be very protective of your retirement savings.

Next to your question about using the 401k:

If you take funds from your 401k or an IRA and you are under 59 1/2 (it sounds like you are) you will have a 10% IRS penalty on the amount you withdraw. There also may be a penalty assessed on the account itself from the custodian. Then there is the tax on the amount withdrawn. Your tax bracket will identify this amount. If I assume you are in the 25% Federal tax bracket and you add the 10% IRS penalty plus your state may tax this income as well at around 5%, you could have a 40% hit in taxes. So you take out $50K and $30K is left to help your parents.

The best option may be to take a loan from the 401k. Loans generally are not allowed from IRAs, so rolling the 401k to an IRA eliminates that option. But you may be able to take a loan from the 401k. This may be allowed and you will need to talk to your employer to identify if this is available and what amount of your 401k is available for loan. If you go this route the loan will need to be paid back over a 5 year period. And if you decide to do a rollover later you may have to pay off the loan before the rollover can be done.

As you can see there are a lot of issues surrounding this event and they need to be applied to your situation with a lot more detail than this service allows. I suggest you get advice from a Certified Financial Planner before you make any decisions on this.

1 Comment   |  Flag   |  Feb 27, 2014 from Powell, OH

The simplest solution is if you're currently saving into an employer sponsored 401k, reduce the percent to as low as any employer match and re-direct the money that would've otherwise gone into your 401k and direct it towards your parents' medical expenses (presuming you have a healthy emergency fund just in case). I agree w/ all the advisor's recommendations and as a CPA myself, the penalties & taxes are a KILLER in that it eats up so much of what you may want to withdraw. While it sounds cruel, don't forgo all the years of compounding & growth of the money in your old 401k to pay medical expenses now. Medical providers are willing to give very generous payment terms. Keep in mind the proverbial rhyme "For Want of Nail" which is a good allegory that small actions have large consequences. In your case, a few thousands now (in withdrawals, taxes, and penalties) could result in missing out in tens or hundreds of thousands in 30 years.

Flag |  Feb 27, 2014 near Oak Creek, WI

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5 votes

Hello Nicole,

I’m sorry that your parents are suffering medical issues. It’s nice that you are willing to help.

If possible it is best that you do not raid your retirement savings at all. If you withdraw funds, unless they are in a ROTH 401(k), you will have to pay income tax on the amount withdrawn and a 10% IRS penalty imposed on taxpayers who make withdrawals before they are age 59-1/2. A home equity line or even a low interest credit card you can repay in a few years would be better options. Another thought is a Reverse Mortgage on their current home. This is a topic for another day but if their home is free of debt then the reverse mortgage is a way to monetize some of their home value without being saddled with debt payments. The loan is paid off when the home is sold which may be after the second to die.

If you must access the funds in your 401(k) it would be better to take a loan then to make a withdrawal. You will not be allowed to take a loan from the funds in your ex-employer’s plan. However, if your new employer’s plan allows, you can roll your old 401(k) into your new 401(k) and then take a loan of up to 50% of the vested balance or $50k, whichever is less. You have to read the Summary Plan Description closely to ensure it will allow you to borrow on the rolled in funds.

The loan will be repaid out of your paychecks for a maximum term of 5 years. If you leave your employer before the loan is repaid you will have to either pay the remaining balance due, usually within 90 days, or suffer a withdrawal of the open balance and the tax and penalty consequences discussed above. The interest paid on the loan will be deposited into your own 401k account. But when you take the interest out one day, hopefully in retirement, it will be part of the distribution treated as taxable income. So if you think about it you are paying interest with after tax dollars then paying tax a 2nd time on the same dollars when you remove the interest in the future. But the largest cost of a 401(k) loan can be the foregone appreciation while the money is out of the plan. If the market goes up 8% a year that’s the cost of the loan.

I hope this helps.

Comment   |  Flag   |  Feb 27, 2014 from Woodbridge, VA

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Nicole, sorry to hear of your parent’s situation; it’s great that you want to step up to try to help. There would be income tax due on your withdrawals, and unless you are 55 years old, there would be a 10% additional penalty. Though you find the situation pressing, it could be a very expensive solution. If you have a 401(k) with your current employer, you could conceivably roll it into your current plan and take a loan up to 50% of your account, not to exceed $50,000. But be certain first that loans are permissible before you roll anything into it. And be aware that, though loans may be a better solution today, there are some potential pratfalls.. First, you are borrowing pre-tax dollars and are repaying them with after-tax dollars. So in a very real sense you are being double taxed. But more importantly, be aware that you must re-pay a loan within 5 years. And if you are separated from your employment, the loan is due. If the loan is not repaid for any reason, it is subject to ordinary income tax plus penalty.

So while it may get your parents out of a tough spot, it will be an expensive, and some would argue, a not very practical solution. Your parents should be able to work out a very reasonable payment schedule with most hospitals and physicians. Even a credit card advance might be a better solution. You, or they, could possibly take an equity line of credit on the house, but that would be secured by the house, putting the house at risk. From a risk point of view, I might recommend a 401(k) withdrawal first

I wish you the best. Hope this helps.

1 Comment   |  Flag   |  Mar 06, 2014 from Delray Beach, FL


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