Raiding retirement accounts can be risky

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As the economy weakens and home equity loans become harder to get, more people might be tempted to raid their retirement plans for living expenses or debt repayment.What they might not realize is how harsh the tax consequences will be.Middle- and upper-income people who take money out of an individual retirement account, 401(k) or other tax-sheltered plan before age 59 1/2 can easily lose half or more of it in federal and state taxes and penalties. "It's a bigger hit than you think," says IRA expert Ed Slott.It's hard to calculate in advance how much a withdrawal will cost you because all of these benefits start disappearing or phasing out at different income levels.For tax year 2008, all taxpayers start losing their itemized deductions when adjusted gross income surpasses $159,950 (except for married people who file separately, who start losing them at $79,975).Married couples start losing personal exemptions -- the $3,500 deduction you get for each spouse and dependent -- at $239,950 in adjusted gross income. Singles start losing it at $159,950. A number of federal and state tax credits are also pegged to adjusted gross income.Many people who raid their retirement accounts underestimate how much it will cost and don't have enough cash on hand to pay the tax when it comes due.The number of people tapping their retirement plans before retirement seems to be on the rise.Fidelity Investments, the largest provider of workplace retirement plans, reported that hardship withdrawals from 401(k) accounts were 17 percent higher in 2007 than in 2006. Loans from 401(k) plans grew 4 percent.It's usually a bad idea to tap a retirement plan for anything other than retirement income. But if you find you must, here are some things you should know.Withdrawals from IRAs and 401(k)s are treated the same in most respects, but different in ways that cause a lot of confusion. First, the ways they are the same: All withdrawals from traditional deductible IRAs, 401(k) and similar workplace plans are taxed as ordinary income. The lower capital gains rate never applies. If you are younger than 59 1/2, you will also owe a 10 percent federal tax penalty, plus a state tax penalty if your state imposes one.The 10 percent penalty can be waived if:-- The distribution was made to your beneficiary or estate on or after your death.-- You took out the money because you are totally and permanently disabled.-- The money pays certain unreimbursed medical expenses.-- The money pays an IRS levy.-- You are a reservist called to active duty during a certain time period.-- The withdrawal is part of a series of substantially equal periodic payments made over your life expectancy. (For 401(k) plans, you must leave your employer to qualify for these penalty-free withdrawals.)Now for the ways they are different.IRA withdrawals:You can withdraw money from a traditional IRA at any time, for any reason.You will always owe income tax, but the 10 percent early withdrawal penalty can be waived for three reasons in addition to the six stated above:-- If you use it to pay certain higher education expenses.-- If you are unemployed and use it to pay certain medical insurance premiums.-- You also can take out up to $10,000 without penalty to buy or build a home if you have not owned a home in the two years before the withdrawal. If you are married, each spouse can withdraw $10,000 without penalty, but a $10,000 per person lifetime limit applies.If you think you qualify for a waiver, ask a tax professional or read IRS Publication 590 at www.irs.gov.401(k) withdrawals:If you are still working for an employer, you cannot take money out of its 401(k) plan at all unless you qualify for what is known as a hardship withdrawal.The IRS allows plans to offer hardship withdrawals for certain limited reasons. A plan does not have to offer hardship withdrawals, but most do.The IRS allows hardship withdrawals to pay for certain unreimbursed medical expenses, certain higher education expenses, funeral expenses, to buy or repair a principal residence or to prevent eviction or foreclosure on your primary residence.Employees must prove they have a heavy and immediate financial need for the hardship withdrawal. If you take a hardship withdrawal, you will still owe tax and, if you are younger than 59 1/2, the 10 percent penalty. You can avoid the 10 percent early withdrawal penalty from workplace plans for any of the six reasons stated above or if you leave your employer in or after the year you turn 55.A final note: Different rules apply to Roth and nondeductible IRAs and to the new Roth 401(k).E-mail Kathleen Pender at kpender(at)sfchronicle.com(Distributed by Scripps Howard News Service, www.scrippsnews.com.)