If you find yourself caught between a financial rock and a hard place, you may wonder if it’s possible—and advisable—to take money out of your retirement plan while you’re still working. The answer to this common question is it depends. When quick cash will provide a solution to a financial problem and your regular savings aren’t enough, tapping into a 401(k) account might be an unavoidable last resort. In the long run, however, depleting your 401(k) funds could do you more harm than good.
It’s important to remember that a 401(k) plan is designed to be a long-term savings account. Because of this, and a 401(k)’s tax-favored benefits, the IRS may impose penalties in certain scenarios if you take money out of your account before you turn 59½. So, depending on why you need the money and your personal financial circumstances, think twice about taking money out of your 401(k) plan. Here are some of the withdrawal options, although you will need to confirm with your human resources or benefits department to confirm what options your company’s plan offers.
- Age 59½: As you may have guessed, if you are 59½ or older, you may withdraw funds from your 401(k) account without incurring penalties for taking the money out. You will have to pay taxes on the amount you withdraw if the money was deposited on a pretax basis.
- Substantially Equal Periodic Payments: Also known as a 72(t) distribution, this is a way for you to withdraw your 401(k) monies if you are younger than 59½ and avoid a 10 percent early withdrawal penalty. A 72(t) distribution is a series of equal payments that must generally continue unchanged for five years or until you reach age 59½, whichever is later. Payments cannot be modified in any way once they begin. So, while this might not be an option for everyone, it could be a lifeline for those who are close to 59½.
- Loans: When you take a loan from your 401(k), you’re borrowing from your own retirement savings account and paying yourself back with interest. Sounds good, right? Not so fast. Borrowing from your 401(k) might provide short-term relief but long-term harm. Here are five reasons to avoid taking a 401(k) loan:
• You’ll be taxed twice because you’ll pay the loan back with after-tax money, which will be taxed again when you ultimately withdraw it for retirement.
• Your take-home pay will be reduced because the loan repayments will automatically be deducted from your paycheck.
• Your taxable income will increase because you’ll no longer be making pretax deferrals while you repay your loan.
• You’ll miss out on compounding because the money you withdraw won’t be invested and therefore won’t earn interest.
• If you leave your company, you may be forced to repay the loan in full, or taxes will be due, and a 10 percent early withdrawal penalty will be assessed if you are younger than 59½.
- Financial Hardship: The IRS allows retirement account owners to withdraw 401(k) funds if they are needed to satisfy a “heavy and immediate financial need,” as defined by the IRS. If you withdraw funds due to hardship, you’ll owe taxes on the untaxed portion of the funds you withdraw and you’ll be assessed—you guessed it—a 10 percent early withdrawal penalty if you’re younger than 59½. A hardship distribution should be taken only after you have exhausted alternative options.
- Special Temporary Withdrawal Rules for Those Affected by COVID-19: Perhaps your financial situation has been adversely affected by the COVID-19 pandemic. If this is the case, you may qualify for a waiver of the 10 percent early withdrawal penalty for retirement account distributions or other retirement withdrawal or loan relief provisions. To qualify, you must meet specific criteria laid out by the IRS. Speak with your financial advisor or tax professional to determine if your situation qualifies you to take advantage of these special rules.
Weigh Your Options Carefully
It’s important to remember that when you withdraw money from your retirement savings account, it is no longer being invested and cannot benefit from compound interest or potential market gains. Withdrawing hard-saved funds from your 401(k) plan is not a decision to be made lightly.
If you have questions about whether you should consider taking a loan from your 401(k), please reach out to me. We can discuss your situation and what options may be available to you. Click here to view my calendar and schedule an appointment that is convenient for you.