Borrowing or Withdrawing Money from Your 401(k) Plan
When you’re feeling a financial pinch in your day-to-day life, it’s hard to look at all of the money you’ve saved up in your 401k and not think about how just a little bit of that money would make your life better. Though a 401k is intended for retirement and there are rules restricting your access to that money until you are 59½ years old, it’s sometimes possible to take an early withdrawal or a loan from your 401k. The question is whether the benefits of doing so outweigh the significant disadvantages. Carefully consider your options before making this decision.
Sometimes a “hardship withdrawal” is allowed during times that you need money. For instance, you might be able to use the money to pay for college, make a down payment on a home, pay funeral expenses for a loved one or to pay medical expenses. Details for this vary based on the plan, and your plan may allow other types of hardship withdrawals.
There are typically limits to how much you can withdraw at once, and any money you withdraw is taxable. In most cases you must also pay a 10 percent penalty for withdrawing the money early if you are younger than 59½. The custodian can withhold money for taxes, but this can frequently be as much as 40 percent. For instance, if you are trying to take $10,000 out of your 401k, you may only receive a check for $6,000. You may get some of that back at tax time, but it won’t be the big cash influx you were expecting.
A Loan from Yourself
The alternative is to take a loan from your 401k. This process is usually pretty simple, although can also have a big impact on your nest egg at retirement. Without a credit check you can get the money and start making payments back to your 401k account. In most cases, the interest rate is low and you won’t feel so bad about paying it because you’re paying that interest to yourself.
However, it’s very important to learn about the details of the loan. If you leave your company or are fired, the loan must usually be paid back within 60 days of terminating employment. This might mean that you have to pass up a good opportunity because you won’t want to leave your current company. Also if you miss a payment for 90 days, the entire remaining balance of your 401k is treated as a distribution. You will have the same taxes and penalties as if you had just withdrawn the money.
A Few Advantages
Taking money from your 401k can solve some of your big financial problems. For instance, if you have high-interest credit card debt, borrowing money from the 401k at a lower interest rate can help you get out of debt. It’s also a convenient source of money when you want to buy a home or go back to college. Furthering your education might mean a significant bump in pay, which could offset the financial setbacks that occur when you take money out of the 401k.
There are a lot of reasons why you shouldn’t take money out of your 401k. First and foremost, you will probably need that money during your retirement. Compounding tax-deferred growth over the years is one of the biggest advantages of having the 401k. Although you are paying the principle and interest back you yourself, you are missing out on potential investment gains that otherwise would have remained invested. On top of that you have the compounding interest lost by borrowing from your 401k. Taking even a few thousand dollars out early means that your nest egg won’t grow as much as it could have; pulling that money out may have some real short-term benefits but can have a huge impact on your retirement.
Taxation can also be a big disadvantage. Taking the hardship withdrawal means that you’ll pay an extra 10 percent in penalties, and adding the extra money from the withdrawal to your income can bump you into a higher tax bracket and eliminate your chances of qualifying for the Earned Income Credit. Though 401k loans are tax-exempt, the money you pay in interest is with after-tax dollars, and it will be taxed again when you withdraw it in retirement. If you default on your loan, the IRS will treat it like a hardship withdrawal and you’ll get hit hard with taxes.
Looking for Alternatives
It’s best to avoid taking money out of your 401k for any reason. When you’re struggling financially, try to look for other ways that you can fix your problems. For example, if you’re thinking about withdrawing money to pay for medical expenses, you might talk to the provider about coming up with a payment plan. Some hospitals will even allow you to do this without paying interest, and some have programs that will cover a percentage of your bill based on income. If you want to pay off credit cards, consider a debt consolidation loan or a home equity loan. These methods will get you the money you need without jeopardizing your retirement.
*As individual situations will cary please note that this material is not intended to be a substitute for specific individualized tax or investment planning advice.