Should I Close My 401K and Withdraw My Funds?
Canceling your 401(k) contributions is easy to do. Go to your human resources department and make a request to stop contributions. There is no penalty for doing so. When the paperwork is completed, you no longer will have a 401(k) contribution deducted from your weekly paycheck.
Withdrawing money from your retirement account, however, may be more difficult.
If you are younger than 59 and ½, you’re going to have to demonstrate that you have an approved financial hardship (e.g. staggering medical bills or disability) or you’re trying to buy your first house or pay for education expenses.
The only other way to get access to your funds is to leave your employer.
If you don’t meet one of those conditions and decide to withdraw money from your 401(k) anyway, there is a 10% penalty for early withdrawal and the amount withdrawn is taxed as income.
Disadvantages of Closing Your 401(k)
Whether you should withdraw money from your 401(k) is another story. Your employer-sponsored retirement plan is designed to provide you with retirement funds, outside of social security. Contributing 5-15% of your income, with an employee match, over the course of your working lifetime should provide you with a substantial sum when you retire. Withdrawing even small sums at any point along the way to retirement will impact your nest egg’s growth potential.
Consider, for example, if at age 35, you had $30,000 in a 401(k) account that was earning 8% interest annually. If you continued to contribute $25 a week until you retired at age 67, you would leave with $526,053!
What Happens If I Stop Contributing to My 401k?
Even if you cancel contributions and just leave the $30,000 in the account, compounding interest would allow it to grow to $352,112.
If you are considering cancelling contributions to a 401(k), you would be better served to merely suspend those contributions. A short-term suspension will slow the performance of your retirement fund, but it won’t keep it from growing. It also will lessen the temptation to simply withdraw all the funds and wipe out retirement savings in the process.
Your Retirement Money Is Safe from Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued or declare bankruptcy, your 401(k) and IRAs cannot be liquidated by creditors to satisfy bills you owe. If you’re having problems managing your debt, it’s better to seek other alternatives than an early withdrawal, which will also come with a high tax penalty (typically, 30-40% of the total).
What About Withdrawing Money from My 401(k)?
It may seem like an easy way to get out of debt to borrow from your retirement accounts for DIY debt consolidation, but you can only borrow $50,000 or half the vested balance in your account, if it’s less than $50,000. You won’t face a tax penalty for doing so, like you would with an out-right withdrawal, but you’ll still have to pay the money back. And unlike a home equity loan where payments can be drawn out over a 10-30 year period, most 401(k) loans need to be paid back on a shorter time table – like 5 years. This can take a huge chunk out of your paycheck, causing you even further financial distress. Borrowing money from your 401(k) also limits the ability of your invested dollars to grow.
Paying off some of your debt with a 401(k) loan could help improve your debt-to-income ratio, a calculation lenders make to determine how much debt you can handle. If you’re almost able to qualify for a consolidation or home equity loan, but your ratio is too high, a small loan from your retirement account, amortized over 5 years at a low interest rate may make the difference.
What About Rolling 401(k) into IRA?
When you leave an employer, you have several options for what to do with your 401(k), including rolling it over into an IRA account.
It’s possible to do the same thing while still working for an employer, but only if the rules governing your workplace 401(k) allow for it.
The negative for rolling the money into an IRA is that you can’t borrow from a traditional IRA account.
Another option when you leave an employer is to simply leave the 401(k) account where it is until you’re ready to retire. You also could transfer your old 401(k) into your new employer’s retirement account.
If you are at least 59 ½ years old, you could take a lump-sum distribution without penalty, but there would be income tax consequences.
Debt Relief Without Closing My 401K
Before borrowing money from your retirement account, consider other options like nonprofit credit counseling or a home equity loan. You may be able to access a nonprofit debt management plan where your payments are consolidated, without having to take out a new loan. A credit counselor can review your income and expenses and see if you qualify for debt consolidation without taking out a new loan.
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