If you have a 401(k) account, that money is earmarked for your future retirement. But if you need money now, you might be wondering if it’s worth withdrawing from your 401(k) to get it.
Even if you’re in the middle of an emergency, raiding your 401(k) is generally a bad idea. Read on to learn why and discover some other options you should consider.
401(k) withdrawal rules
The U.S. tax code makes it possible for employees of private companies to set aside cash in a 401(k) account for their retirement. Depending on the type of 401(k) account, your contributions may be deducted from your income in the current tax year, or they’ll grow tax-free over time.
But regardless of the type of account you have, there are strict rules as to when you can withdraw cash and for what purpose. If you take an early or non-qualified withdrawal, you could end up paying income taxes and a penalty tax.
What counts as an early withdrawal?
You generally need to wait until you reach age 59 1/2 to make withdrawals from your 401(k) account free and clear. If you take money from the account before then, you may have to pay income taxes on the withdrawal amount plus a 10% penalty tax.
So, let’s say you withdraw $10,000 from your 401(k) to use for a down payment on a new home. If your effective income tax rate is 20%, you’ll owe $3,000 in taxes on the withdrawal. That’s an immediate 30% loss on that money.
Are there any exceptions?
The government understands there are some situations where it would be helpful to have your 401(k) funds, especially if you’re struggling financially.
As such, certain withdrawals may still be taxable as ordinary income. But it won’t come with the extra 10% early withdrawal penalty.
Here are some of the main exceptions:
- Death – if you die, the funds are distributed to your named beneficiary
- You’re rolling over your 401(k) funds into another 401(k) or an individual retirement account
- You’ve made excess contributions (you can only contribute up to $19,500 in 2020), and you’re taking a distribution to correct the mistake
- You become permanently disabled
- Retirement – if you retire early and are at least 55 years old
- You withdraw money for unreimbursed medical expenses that exceed 10% of your adjusted gross income
- You begin a series of substantially equal payments
- Your withdrawal is related to a qualified domestic relations order
Even if you can skip the early withdrawal penalty, though, don’t forget about regular income taxes.
“You must consider the impact a distribution would have on your taxes,” says Crystal Rau, a CFP at Beyond Balanced Financial. “Any distribution, unless it’s a Roth 401k, is going to be considered taxable income and can push you into a higher tax bracket that you did not anticipate.”
Another way to take money from your 401(k) account is to take a loan from the account. By doing so, you’ll be able to escape early withdrawal taxes and penalties. That said, there are other pitfalls that could become even more costly.
Also, depending on your 401(k) plan administrator, you may not be able to get a loan at all. Some plans simply don’t offer them. So, you’ll need to ask your Human Resources representative about your options.
401(k) loan rules to know
If you’re thinking about taking out a loan from your 401(k), the first thing you need to know is that you’re limited on how much you can borrow. According to the tax code, you can borrow the lesser of:
- The greater of $10,000 or 50% of your vested balance
So, let’s say you have a $40,000 balance on a 401(k) and only $30,000 of it is vested. In this situation, you’ll only be able to borrow up to $15,000. “If you take the loan, you are required to repay it over a maximum five-year period, typically through payroll deductions,” says Rau.
Another rule that could spell trouble is if you quit your job or get laid off while you’re paying down your loan.
The plan administrator could require you to pay back the loan in full within 60 days — even if you just took it out and had years left on your repayment plan.
If you can’t manage to pay back the loan in that time frame or you keep your job and still default, the plan administrator will report the full amount of the loan as an early withdrawal.
That means you’ll be on the hook for income taxes and the 10% penalty tax.
To give you an idea of how likely that is to happen, the National Bureau of Economic Research found that 10% of all 401(k) loan borrowers defaulted on their loans in 2015. And 86% of 401(k) loan borrowers who left their company with an outstanding loan couldn’t pay it off.
The most significant cost of a 401(k) loan
Interest and potential taxes could make a 401(k) loan a costly mistake. But your lost gains will be the biggest cost. For example, let’s say you borrow $15,000 at a 6% interest rate for five years. Over that time, you’ll pay $2,400 in interest.
Now, if you earn 7% annually on your 401(k) account during that same time, the $15,000 you borrowed could have been worth $21,038. That means you’ll lose out on $6,038 in earnings on top of the $2,400 in interest.
So, even if you don’t default, your $15,000 loan will cost you $8,438 in the end.
Alternatives to 401(k) withdrawals and loans
If you need cash to finance a large purchase or to cover some emergency expenses, there are plenty of reasons to avoid taking money from your 401(k). There are other options that could be better for your situation. Make sure you carefully consider each one before making a decision.
A personal loan is generally unsecured, which means you don’t need to put up collateral to get approved. You can use a personal loan for just about anything. This makes it a great solution for many cash needs, including immediate ones.
Depending on the lender and your credit/financial situation, you may qualify for a single digit interest rate. But some lenders charge upwards of 30%, or even higher, if you have poor credit.
To see if a personal loan is right for you, get pre-qualified offers from top lenders within minutes. Doing so will not hurt your credit score.
If you’re looking to consolidate high-interest debt or finance a large purchase, a credit card with a 0% APR promotion could help you achieve your goal without paying any interest at all. But there may be some costs, of course.
For example, some balance transfer credit cards charge a transfer fee of 3% to 5% of the amount you’re transferring to consolidate. But you could save a lot of money if you pay off your balance before the 0% APR promotion expires.
If you’re looking to finance a home improvement project, a home equity loan or home equity line of credit (HELOC) might make sense for you. These loans are typically based on and secured by the equity in your home.
They generally charge low interest rates, but can be high in costs and take a while to process. Also, you could lose your home if you default.
If you’re looking to buy a home or refinance, a mortgage loan will be your best bet. These loans typically charge low interest rates and offer long repayment plans. Plus, the interest you pay is tax-deductible.
Which option is right for you?
Keep in mind that the alternatives listed above typically require you to have good to excellent credit to get approved with a reasonable interest rate.
“[A 401(k) loan] offers flexibility for someone who doesn’t have the best credit score and would be in a position where they would have to resort to payday loans or high-interest credit cards,” says Rau.
So, as you consider all of your options, take the time to understand what makes the most sense for your needs and situation. Carefully count the costs in terms of interest rates and fees. And think about whether you can get the cash another way, or if you need it at all.
In addition to the alternatives we’ve shared, Rau also recommends trying a side job to earn some extra cash, especially if you don’t need the cash right now. Additionally, you can ask a trusted family member or friend for a loan.
The more time you spend going through this process, the easier it will be to avoid any costly mistakes.