Your 401(k) plan sets the stage for your retirement – but is it ever okay to raid the account before you reach retirement? There are penalties in place to discourage taking money out early; however, more than one-third of 401(k) participants dip into retirement accounts early.
Let’s explore the penalties associated with early withdrawals and why it may or may not be a good decision for you.
Penalties for Early Withdrawals
Money withdrawn from your 401(k) prior to the IRS-mandated age of 59 ½ makes that money subject to an additional 10% of the withdrawal value on top of the taxes you’ll pay at your regular income rate. Those surprise expenses can mean that a withdrawal of $15K will end up as $10K after taxes and penalties – a pretty big chunk of change.
Another withdrawal type – a loan against your 401(k) – may seem pretty harmless on the surface, but beware. Just missing one payment against borrowed money might make the full loaned amount subject to tax penalties.
And if you leave your job or get fired – depending on the plan –you may have to pay back the loan in its entirety, immediately. In general, a 401(k) loan must be repaid within five years unless you use the loan to purchase your home.
Why Would You Raid Your Retirement Account Early?
There are some life circumstances that may compel you to dip into your retirement savings such as sudden medical bills or tuition payments. Considered “hardship” withdrawals, you will need to demonstrate your need as immediate and have no alternative for satisfying the payment.
Note: Hardship withdrawals do not have to be paid back but be sure to check the rules of your plan to see when you can begin contributing again to that plan after hardship.
Common Reasons People Withdraw Early
Even if your 401(K) or 403(b) retirement plan allows you to withdraw money, the IRS will still exact a 10% penalty. Here are the circumstances that may have you considering raiding your account:
- To pay funeral expenses.
- To pay health insurance premiums if you become unemployed.
- To pay medical expenses.
- To pay higher education expenses.
- To buy or repair a principal residence.
- To make mortgage payments that would prevent foreclosure of your principal residence.
There are some exceptions to the 10% penalty, such as death, becoming disabled or call to active military duty. Check with your individual plan paperwork or administrator before taking any type of hardship or loan.
Is It Worth It?
Basically, there’s a strong case for taking a hands-off approach to your retirement accounts:
- You will owe tax plus 10% on early withdrawals
- Borrowed money can’t grow
- Hardship withdrawals cannot be repaid and taking a hardship withdrawal may freeze your ability to contribute for up to six months
- Retirement loan interest is not deductible. However, a conventional mortgage or home equity loan may be tax-deductible, costing less on an after-tax basis than a retirement plan loan
- Plan loans are due in full when you quit or get fired from your job before age 59 ½. So, be sure you love your employer or recognize the signs that he/she is unhappy with you!
- Best tip of all – Federal law gives 401K plans exclusions from bankruptcy. So, if your finances go down the tubes, you won’t run the risk of having your 401(K) taken by the court to pay creditors.
All in all, try to make raiding your retirement plan your absolute last resort. One sure way to do this is having a retirement strategy in place that includes building an adequate emergency fund.
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