As a result of a lengthy recession and a slow, weak economic recovery, many people are now facing a mountain of debt. Credit card bills, medical bills, and other everyday issues that arise combined with stagnant wages have caused many people to feel as though they are losing their grip on solvency. Faced with deteriorating finances, many people are tempted to dip into their 401(k) accounts to pay off these growing debts. But depending on your economic situation, this could be a very bad idea.
Fees And Penalties
Assuming your employer allows hardship loans to be taken from your 401(k) balance, you will still more than likely be penalized or charged fees to access the funds. In addition, you may be prohibited from contributing to your 401(k) for several months (up to a year) after making any kind of hardship withdrawal. This may be true even if you pay back the money you borrowed.
Depending on how much you borrow from your 401(k), and how long you have to wait before you can resume making contributions, the long term impact of taking out a loan against your retirements savings could result in a major loss in retirement savings.
Some employers require workers to repay loans from their 401(k) accounts in as little as 60 days. Failure to meet this deadline subjects you to heavy tax penalties. If your current financial situation will allow you to meet these terms, then taking out a portion of your 401k may be the right move for you.
Another downside to taking out part of your retirement savings is that you also lose the tax deferment you gained when you deposited the funds into the account. Basically, when you contribute to a 401(k) plan, the money comes out of your pay before taxes. Now that you will be collecting that money, you will need to pay Uncle Sam his portion (usually around 10%) as well as declare the full withdrawal amount as income on your federal tax return for that filing year. And don’t forget state income tax as well – usually another 10%.
In many cases, the IRS also imposes penalties for making withdrawals from your 401(k) before you reach the minimum retirement age (even if they are loans and you pay the money back). Basically, if you are under age 55 and no longer working, or under age 59 1/2 and still actively employed, you can expect to be required to pay an early withdrawal penalty for accessing the funds that were meant for your retirement years.
So how steep are these penalties? Unless you qualify for a hardship exemption, you will have to pay an additional 10% penalty for withdrawing funds from your account before the legal retirement age. This means that you are now being taxed 10% to pay Uncle Sam, another 10% for state taxes, plus an additional 10% early withdrawal penalty gets taken. So you will need to borrow enough money to cover these additional amounts, while still leaving you enough to cover what you needed the money for in the first place.
Do You Qualify for a Hardship Exemption?
If you meet certain requirements, such as becoming age 59 ½ or older or becoming disabled, the IRS will not impose its penalty on your withdrawals. Likewise, if you die, your heirs can make withdrawals from your 401(k) without penalty as well. Otherwise, you must qualify for a hardship exemption to escape the early withdrawal penalty.
The IRS is the one who sets the rules when it comes to determining whether or not you qualify for a hardship withdrawal. Hardship withdrawals are only permitted for what the IRS calls “immediate and heavy financial need.” These very strict guidelines include allowances for the following:
- Medical care for yourself or a member of your immediate family
- Purchase of a primary residence
- Tuition, room and board or related educational expenses occurring over the next 12 months for yourself or your immediate family
- Prevention of eviction from a rental or foreclosure on a home which is your primary residence
- Repair expenses to a primary residence
- Funeral expenses
If you qualify for a hardship exemption, you may only withdraw enough money to cover the specific expense, plus any federal or state income taxes that you must pay on the money you withdraw. You also must demonstrate that you have no other means of obtaining the money you are in need of.
After considering the potentially heavy losses associated with borrowing from a 401(k), you may decide that a personal loan is a better alternative for you to be able to pay off some debts and get back on top of your finances. When borrowing money through a personal loan, it is a good idea to only borrow what you actually need, similar to borrowing from your 401(k) account.
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While you will have to pay interest on the loan, this amount may actually end up being less than the financial impact of a 401(k) withdrawal when you take into account all of the fees, taxes and IRS penalties. Plus, with a personal loan you will have several months or even a year or more to repay the money (if you get it from the right place), as opposed to the 60 days your employer may enforce.
Cutting back on expenses is always the preferable first step to addressing your debt. At the same time, paying off high interest credit card balances and other debts may be just the boost you need to get back on solid financial footing. But rather than raiding your 401K, consider a personal loan from an installment lender to get you back on track. Not only will your nest egg remain intact, you could build your credit score in the process, giving you access to better terms for the future.