Why a 401(k) Withdrawal Should Be Your Last Resort - 401k Maneuver

Why a 401(k) Withdrawal Should Be Your Last Resort

If you’re thinking about making a 401(k) withdrawal right now to pay off high-interest debt, help make ends meet, or have extra cash on hand, you may want to think again.

Or at least educate yourself on the possible consequences, so you make the move with eyes wide open.

Keep reading to find out the withdrawal rules, why withdrawing from your 401(k) right now might be more detrimental to your financial future than you realize, and 7 possible alternatives that won’t impact your retirement.

Difference between a Withdrawal and a Loan

 401(k) withdrawal

Before we dive into the 401(k) withdrawal rules, it’s critical we clear up a misconception: withdrawing money is the same as taking a loan. The two options are very different and, thus, have different consequences.

  • With a 401(k) withdrawal, you take money from your savings, and you don’t have to pay it back. You will have to pay taxes on the money withdrawn and possible penalties.
  • With a 401(k) loan, you borrow from yourself and you have to pay it back with interest, typically within 5 years of taking the loan. It is not a distribution. You do not have to pay penalties and taxes should you pay it back on time. And, the interest you pay on the loan goes back into your retirement savings.

[Related Read: The Downside of 401(k) Loans: Investors Beware ]

401(k) Withdrawal Rules 

 401(k) withdrawal

If you want to take a withdrawal from your 401(k), you need to be at least age 59½ to avoid paying an early withdrawal penalty to the IRS. 

These withdrawals are subject to ordinary income tax on the amount you withdraw plus a 10% early withdrawal penalty – unless you qualify for a hardship withdrawal, where the penalty may be waived. 

Hardship withdrawals are defined by the IRS as taking money out of your 401(k) because of an immediate financial need that’s limited to the amount to satisfy the need. The need of the employee also covers the employee’s spouse or dependents. 

Whether you qualify for a hardship withdrawal depends on certain circumstances “deemed to be immediate and heavy” defined by the IRS as a hardship.¹

These include:

  • Certain medical expenses.
  • Costs relating to the purchase of a principal residence.
  • Tuition and related educational fees and expenses.
  • Payments necessary to prevent eviction from, or foreclosure on, a principal residence.
  • Burial or funeral expenses.
  • Certain expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under IRC Section 165.²

Again, the amount of money you can withdraw is limited to what you need to cover the hardship – not what you want. 

If you qualify for a hardship withdrawal, the money you take out will be taxed as ordinary income if you are under age 59½, but you won’t have to pay the 10% penalty.  

Note: Some plans allow a non-hardship withdrawal – others don’t. All plans are different, so check with your plan provider for details.

3 Reasons Not to Take a 401(k) Withdrawal

 401(k) withdrawal

While we understand you may need money right now, we recommend withdrawing from your 401(k) as a last resort for a variety of factors. 

The first thing to understand is the money is NOT immediately available to you. Each plan has a different set of rules it must follow so it may take weeks to get the money from your 401(k). 

And if you’re looking for a quick cash injection, withdrawing from your 401(k) is NOT going to help you in the short term.

#1 You May Negatively Impact Your Financial Future

The advantage of using a 401(k) to grow your retirement savings is that you grow your money tax-deferred.

If you consistently contribute, year over year, your money grows and grows. That’s the power of compounding.

And that’s why we recommend you avoid withdrawing money until you retire because you may never be able to replace that money.

According to the Center for Retirement Research at Boston College, early withdrawals reduce overall 401(k) assets for retirement by 25% on average.³

Research conducted by Employee Benefit Adviser shows, “A hypothetical 30-year-old participant who cashes out a 401(k) savings balance of $5,000 today would forfeit up to $52,000 in earnings the sum would have accrued for them by age 65, if we assume the account would have grown by 7% per annum.”

#2 You May Lose More Money Withdrawing Right Now

One of the worst times to withdraw is when the market is down.

Remember, you don’t lose money when the market is down, unless you cash out at the bottom.

Taking a 401(k) withdrawal when the market is low means you have to withdraw a larger percentage of your account.

#3 Taxes Are Still Due

As mentioned above, whether you qualify for a hardship withdrawal or not, you must pay taxes on the amount withdrawn – and it’s considered ordinary income.

The last thing you want to do is get cash for a short-term need, only to find out it’s bumped you up to the next tax bracket. 

If you’re willing to take the tax hit, we still recommend you speak with your CPA or tax professional to find out the real cost of cashing out. Because at the end of the day, the cost may outweigh the need.

7 Alternatives to 401(k) Withdrawals

 401(k) withdrawal

If you want to protect your future retirement savings, do everything in your power to find alternatives. 

Here are a few ideas that don’t involve jeopardizing your retirement:

  1. For qualified medical expenses, use HSA savings.
  2. Apply for a 0% credit card, put the money on that card, and then pay off interest-free before the interest-free promotional period expires.  
  3. If the need is medical, there are numerous companies that provide financing options, such as CareCredit.com.   
  4. Tap into other non-retirement savings, such as emergency savings or brokerage accounts. 
  5. Ask a family member to loan you the money. 
  6. Use your home equity line of credit. 
  7. Take out a personal loan.

Speak with a Professional

 401(k) withdrawal

Before you touch your 401(k), we recommend you speak with a third-party professional  who can help you make the best decisions possible – for right now and the future.

If you are financially hurting or uncertain about your financial future, please do not wait to speak to an expert about your situation. 

401(k) Maneuver is committed to providing you resources to help you make the best possible decisions about your financial and retirement future.

Have questions about your 401(k)? Book a complimentary 15-minute 401(k) Strategy Session with one of our advisors.

Book a 401(k) Strategy Session

Sources:

  1. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions#2
  2. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions#2 
  3. http://crr.bc.edu/wp-content/uploads/2015/01/IB_15-2.pdf 
  4. https://www.employeebenefitadviser.com/opinion/to-show-participants-you-care-help-them-avoid-401k-cash-outs 
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