It’s tempting to tap your 401(k) when you find yourself in a tough spot because it may seem like you’re simply borrowing from yourself. However, tapping your 401k before you turn 59 ½ has many drawbacks and should only be used as a last resort.
Tax Exemption Loss and Early Withdrawal Penalty
The money you take out of a 401(k) loses tax-exempt status if you withdraw before you turn 59½. It will be taxed primarily as income, and you’ll have to pay the 10 percent early withdrawal penalty.
Many companies offer loan provisions in their 401k plans that allow you to borrow up to 50 percent or $50,000 of your savings without the 401k withdrawal penalty, but there are several factors to consider. This loan must be paid back with interest within five years. Additionally, if you leave your company for any reason, you would have to pay back the loan immediately. If you can’t make the payments, the loan is calculated as an early withdrawal, and you would have to pay taxes and the 10 percent penalty fee.
Hardship withdrawals are offered by some employers when an individual has severe financial need. For those who are offered these withdrawals, there are a limited number of ways you can use those funds, such as expensive medical bills that are not reimbursed. It’s important to keep in mind, however, that the government does not require all companies to offer them, so your 401(k) shouldn’t act as an emergency fund.
Hardship withdrawals aren’t hit with the 10 percent 401(k) withdrawal penalty, but they don’t come without a price. Companies usually keep about 20 percent of the withdrawal to cover taxes and often d not cover the entire penalty fee.
If you need to access extra money, there are several alternatives to tapping your nest egg so you don’t have to face the 401(k) withdrawal penalty.
- Talk to your lender to discuss your loan payment structure.
- Reach out to generous family and/or friends who can help you through a rough spot.
- Tap other assets that have fewer consequences. For instance, you could take out a home equity loan or obtain a loan against a life insurance policy.
While there may be some circumstances where you would consider tapping your 401(k), the costs often outweigh the benefits. There are several alternatives, and ultimately, you don’t want to sacrifice your retirement savings for a short-term cost.