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Does Withdrawing Money From Your 401(k) Make Sense?

Carl Andrews

Financial Advisor
Updated: 7/2019

Does Withdrawing Money From Your 401(k) Make Sense?

For those having a retirement account that’s employer-sponsored, it never makes sense to dip into it because this can seriously affect your post-retirement life. However, this stands to be an option if you can’t resort to balance transfers or other loans.

Even though this loan doesn’t appear on your credit report, your inability to repay will result in substantial penalty along with taxes on any unpaid balance, leaving you struggling with an additional debt burden. A 401(k) loan is typically due in 5 years, unless you are pink slipped or quit. In such cases, it becomes due in 60 days.

Background

Dipping into your 401(k) account never really makes sense and is generally a last and desperate attempt made by many to get out of a debt trap. Rather, it should be treated more like a lockbox which needs to be funded aggressively, monitored judiciously and rebalanced annually. To reiterate, never, ever prematurely dip into your 401(k) if you have other options available.

Even though loans from a 401k account cost less, you will have to explain why you need it so badly. Any withdrawals before the age of 59 years and 6 months attract a 10% penalty, receivable by the federal government and you will have to pay taxes on the amount you claim along with withholding. For instance, if you want to withdraw $20,000 from your 401k account, you will end up paying something around $28,000 which comprises the 10% penalty and 25% withholding charge to get it in hand.

This 10% penalty charge, however, may be waived even if you are younger than 59 years and 6 months if you are borrowing to buy your first house; paying for medical expenses due to a sudden disability; footing higher-education expenses for self or your offspring; paying to avoid foreclosure or eviction; getting your house repaired after a natural calamity has damaged it; for funeral expenses of a spouse, parent or child; or your employment is terminated when you are 55 years of age.

Why resort to 401(k) Withdrawal?

It should only be immediate and heavy financial requirement that should compel you to withdraw from your 401k account and where it is impossible for you to resort to a commercial lender for financial aid under any circumstances. It’s more like a push coming to shove situation where you just don’t have an alternative. However, should you find any other alternative route to find a way out of your financial crises, just avoid any withdrawal from your 401(k).

A 401(k) withdrawal may be calamitous because not only are you eroding your future resources but also inviting brutal penalties from the IRS and paying some serious amounts of income tax on your withdrawal during the financial year.

Even though getting a loan from a 401k plan costs less, it is still not advisable. You also need to consult with a plan administrator to check first whether you are entitled to a withdrawal. In almost all cases, the loan taken has to be for a genuine hardship, which cannot be tackled by any other means and the borrower needs to explain in details how he is going to spend his money before the withdrawal is allowed.

When you make a hardship withdrawal, it’s best to do it after the age of 59 and a half years as most IRS penalties at that age become inapplicable. Otherwise, as stated earlier, you would have to pay penalties of around 10% penalty, which is grabbed by the federal government right away.

How to Avoid a 401(k) Withdrawal?

Financial experts opine that limited access to hardships and loans is a crucial incentive for people to enroll voluntarily in a 401(k) plan and subsequently, feel relieved to defer a higher amount of the pay they receive. Enrollees are actually sacrificing their additional take-home pay for a more comfortable retirement. If backdoor access to those funds is allowed, it encourages savings that might otherwise not happen.

But should you decide to avoid your 401(k) withdrawal, you have the following options at your disposal:

  • Negotiating current interest rates with your credit-card issuer. Anyone with a high credit score could trim these rates by a number of percentage points.
  • You can make extra payments that will reduce the charged interest and shorten the loan period.
  • In case of student loans, you can consolidate them with other existing loans at better rates. If your personal credit score improves after the loans were initiated, you could approach online lenders for some further refinancing.
  • Scour opportunities for personal loans which could be collateralized or unsecured for consolidating your personal debt at lower rates of interest.
  • You could also liquidate certain assets like jewelry, fancy, and expensive electronic items, a part of your portfolio for non-retirement such a car that you don’t use or any other vehicle.
  • Take on additional employment to enhance your income.
  • You can also ignore your existing 401(k) because most employers usually don’t mind if your old 401(k) stays in their fold even if you quit the job. In case you’ve taken up employment elsewhere which also has a 401(k) program, rolling the old fund into the new one is strongly advised.

What Happens When You Make a 401(k) Withdrawal?

When you borrow from your 401(k) plan, you are required to start repaying precisely within 90 days of receiving the funds. In case you don’t, the “loan” becomes a “distribution” and is regarded as a taxable income that attracts a penalty of 10%. If you have discontinued the job which had your 401(k) plan, take your IRA choices into consideration.

When you opt for a traditional rollover, you stand to protect your savings for retirement from penalties and taxes. This calls for acting expediently because time restraints exist. The next alternative is to go to a Roth IRA where you need to pay upfront income tax but also enjoy the privilege of avoiding penalties. When you retire, you can take out the growth portion free of taxes.

However, when looking into rollover options, check out the expenses and fees involved; options for investment; security and liquidity; and extended lifespan, which in other words implies how long a person is expected to live after he retires.

Statistics published by The Social Security Administration show that anyone who survives till 65 years of age can expect a further average lifespan till age 84.3. This is for men while women who survive till 65 can expect living up to 86.6 years of age. Of course, these are averages and statistics also reveal that 1 person in 4 who live up to 65 years, cross the age of 90 while 1 in 10 live past the age of 95.

That’s why it’s all the more important to remember that should you live long enough to finally retire, you may have a long life even after that. And money would be definitely required to survive. Compromising your future by jeopardizing your 401(k) plan right now, therefore, does not make too much sense.

 

Withdrawal Without Penalty

All, however, isn’t lost when you make a withdrawal from your 401(k) plan because under certain conditions, tapping is allowed without penalty.

You don’t need to pay anything extra for funds withdrawn for funeral and/or burial expenses; to get disaster relief; expenses for higher education for yourself or dependents; buying a house for the first time; your physical disability and inability to earn and for paying medical bills on emergencies. The latter however, have certain restrictions. It also applies if you are above the age of 55 and have chosen to take premature retirement, or you have suddenly lost your job and are unable to find fresh employment.

 

Pros of a 401(k) Loan

In case of short-term financial crises, your employer will most probably allow you to get a loan against its 401(k) plan. Subsequently, you can pay it back by way of payroll deductions, which implies that you’re paying yourself back essentially. However, as long as you don’t pay back the loan amount, it does not earn any interest and moreover, the interest that you are paying on the said loan is not tax deductible. This, in other words, implies that an extra cost factor is involved for what apparently seems like “free” loans.

But even then, it’s always better than to withdraw money from other sources of retirement funding such as IRAs. You will have to deal with the 10% tax as a penalty when you withdraw from an IRA, unless you are lucky to be an exception such as using the fund to pay for your or a dependant’s college education, sudden and unforeseen medical expenses, or if you are buying a home for the first time.

The greatest advantage of having a 401(k) plan is its ready accessibility and the fact that your employer is also paying a matching amount every month, which you can tap into. However, at the end of the day, the taxes and IRS penalties exist, and you end up being the loser in the long run.

Therefore, the most ideal long-term advice would be to keep investing as much as possible in your 401(k) plan as long as you are working and let it grow with the blessings of the compound interest it keeps gathering over the years. As you you get through this, you will realize its enormous value in helping you survive and you can thank yourself for not having tapped into it your 401(k) even when you were in dire need of funds.

 

Cons of a 401(k) Loan

Your 401(k) actually earn over time. However, if you decide to take out money from it, you are forfeiting the potential gains of the amount you have withdrawn. If you are not investing right now, retirement means not relying on wages and on your 401(k) alone. Worse, borrowed funds here are taxed twice. First, on wages when you are still working. Next, on the withdrawn funds when during your retirement.

The most obvious disadvantage perhaps is that this loan means putting less money in your retirement fund as a portion of it is being used to pay off your loan. Therefore, not only are you forgoing lost earnings from the loan, you are also not reaching its potential face value. Moreover, if the plan does not allow you to contribute while there is an outstanding loan, you can miss on your company’s matching funds.

Lastly, if the company that you are currently working for goes out of business or if you quit your job for any reason at all, your entire loan will have to be settled within 60 days. So, ask yourself, how sure are you that you will still be employed in the same place for the next few years? If you fail to pay the outstanding balance, the loan defaults and you pay tax on the outstanding balance and a 10% early withdrawal fee if you are 59 ½.

For the people who are looking to ease their financial troubles with a 401(k) loan, they can end up in a situation worse than they were at in the beginning. Even settling the loan is not paying yourself back because the interest rate is pretty low too. Instead, you are missing out on a lot of potential fund growth.

However, there are still good reasons for you to consider this loan. First is if you are sure that there is going to be money coming in like an inheritance. No matter what the economic climate, that money will not decrease in face value and will still be yours. So, if you are rushing to close the deal on a house, your 401k can temporarily cover the expense.

To some, it also makes sense to use their retirement fund for education or for business. Both are investments, but because of the potential penalties that come with this loan, you should really think about it first. With a financial counselor or an objective third party, weigh the benefits and the costs before you decide.

Carl Andrews


Carl has years of experience helping people tackle debt. As a Senior Financial Advisor, he knows the ins and outs of debt consolidation and debt management. He holds a Masters Degree in Finance and according to him, not all debt problems are the same and that’s why it’s important to take a look at the different options available for your situation.

 

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