Doug Hutchinson
401k Withdrawal Rules: Know Before You Cash Out
When you leave a job — to retire, pursue other opportunities, or due to termination — you’ll have the option to cash out your 401(k). Receiving a big...
Unexpected illness, an emergency home repair, or job loss can create financial turmoil. In the midst of a crisis, withdrawing money from your 401(k) or 403(b) may seem like a good idea. That money is just sitting around anyway and you have plenty of time to pay yourself back…right?
Withdrawing money from your retirement account may solve a short-term problem, but there are long-term consequences — as the charts in this article illustrate. Before you make any money moves, make sure you understand the negative effects of early withdrawals and 401(k) loans and consider other ways to meet an immediate financial need.
Is it smart to borrow from a 401k to pay off debt?
Emergency expenses and credit card debt are the top three reasons people borrow from their 401(k) or withdraw money early. Some would argue that paying off a high-interest credit card using money from your retirement account is a good idea. But withdrawing money from your 401(k) before the age of 59 ½ is generally a bad idea because of the penalties and taxes. A 401(k) loan may be a worthwhile option for some, but it comes with significant drawbacks.
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401(k) Loans vs. Withdrawals
Before delving into all the pros and cons, let’s define the difference between a 401(k) loan and an early withdrawal.
- 401(k) Loan: You borrow money from yourself and repay the loan — with interest — typically over five years. You can typically borrow up to 50% of your vested balance or $50,000, whichever is less depending on your plan.
- 401(k) Withdrawal: You remove money from your retirement savings permanently. If you’re younger than 59 ½, you’ll pay taxes on the amount withdrawn and a 10% early withdrawal penalty. In practice, a $20,000 withdrawal could net only $15,000 depending on your tax rate.
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What about hardship withdrawals?
Some retirement plans allow you to take money out of your retirement account sans penalty to cover emergency medical expenses, funeral expenses or to prevent foreclosure on your primary residence. The penalty is only waived if “the employee couldn't reasonably obtain the funds from another source” and you still have to pay income tax on the amount withdrawn. Learn more about hardship withdrawals on the IRS website.
Additionally, Section 115 of the SECURE 2.0 Act allows emergency distributions of up to $1000 penalty-free. Distributions can be made from a 401(k), 403(b) or 457(b) account to address an immediate need. You don’t have to pay yourself back, but if you don’t, no additional emergency withdrawals are allowed for three years.
The Hidden Costs of 401(k) Loans
- Lost Investment Growth: While you're repaying the loan, your borrowed funds are not invested in the market, missing out on potential gains and the power of compounding.
- Reduced Contributions: To repay the loan, you might be tempted to reduce or pause your 401(k) contributions, further hindering your retirement savings.
- Double Taxation: You’re repaying the loan with after-tax dollars which will then be taxed again when you withdraw this money in retirement.
- Job Loss Triggering Immediate Repayment: If you leave your job or are let go, you may have to repay the loan immediately. If you can’t, the funds are considered a distribution, which means you’ll pay taxes and a 10% penalty if you’re under 59½.
Alternatives to 401(k) Loans and Withdrawals
The best way to avoid taking money out of your retirement savings is to establish an emergency fund. Ideally, you should have enough cash or other liquid assets to cover several months of living expenses. Your age, family size and risk for common financial challenges should be considered. A financial planner can help you calculate the size of your safety net.
If you have significant equity in your home, a Home Equity Line of Credit (HELOC) might be a good option. HELOCs often have lower interest rates than credit cards or personal loans.
A third, less attractive option is to take money out of a Roth IRA or Roth 401(k) if you have one. Because contributions go in after tax, you can withdraw them tax and penalty-free. Note: only contributions not earnings may be withdrawn without taxes or penalties in most cases if you’re under 59 ½ .
Is a 401(k) loan ever a good idea?
Generally speaking, no. But if you have significant high-interest debt and no other options, taking a loan from yourself is better than giving money to creditors or facing bankruptcy. A financial advisor can review your situation and offer personalized recommendations.
Questions? Our friendly and experienced advisors are happy to help. Contact us online or give us a call at (415) 541-7774.
Related Reading:
- 401k Withdrawal Rules: Know Before You Cash Out
- Multiple Retirement Accounts? Here’s What To Consider…
- What To Do (and Not Do) After Being Laid Off
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