Should I Withdraw Money From My 401(k)?
So, there’s this nice pot of money with your name on it, promised to some vague future day to your vague future self.
However, an opportunity (or a hardship) has come along and you’re asking yourself: Should I withdraw money from my 401(k)?
The short answer is no.
That answer is promoted by everyone from your company’s 401(k) plan administrator to your grandmother, who remembers when grandpa recklessly succumbed to temptation, hit up the 401k account early and they wound up living in a mobile home park in Zephyrhills, Fla.
Yes, you sure could make things easier with a pile of cash just now. And yes, there it is, sitting in your retirement account, offering you a way out.
But the answer is still no. Better yet: Absolutely not!
You should think of your 401(k) as a lockbox. Philosophically, this isn’t complicated. When it comes to your 401(k) during your working years, there are five essential rules:
- Establish a plan you can sleep with.
- Fund it aggressively (at least to the level of your employer’s match).
- Monitor it judiciously.
- Rebalance it annually.
- Reduce risk as you get close to retirement age (see Rule No. 1).
Except that’s not it at all. As former heavyweight champ Mike Tyson said, “Everyone has a plan until they get punched in the mouth.”
Sometimes, our financial lives are like a brawl, causing us to chuck the best-laid plans when push comes to shove and we’re suddenly getting pummeled on the financial ropes.
Fortunately, there are ways around most financial crises, and prematurely withdrawing from your 401(k) should be a last, final, terminal, inexorable resort.
Withdrawals can be calamitous. Not only are you taking funds from your future self, in most cases you’re sabotaging your current self with brutal IRS penalties and serious same-year income tax implications.
As with most personal retirement funds, 59 1/2 is the magic age when IRS penalties fall away. Most withdrawals before that age trigger a 10% penalty, and that penalty is sent straight to the federal government. You never see it.
Also, income taxes are due on whatever amount you claim. Withholding will occur. What, you think the IRS is going to trust you to come through next April 15? Are you kidding? You’re tapping your 401(k)!
If you need $20,000, in most cases you’re going to have to gouge your retirement fund for somewhere in the neighborhood of $28,000 (10% penalty, plus 25% withholding) to get it.
But wait. There are certain exceptions for which the IRS waives its 10% fee. Because conditions vary, consult your individual plan. Generally, you may be able to withdraw money without penalty before you reach 59 1/2 if your planned use meets the following narrow criteria:
- Your first home purchase
- Medical expenses following the onset of a sudden disability
- Higher-education expenses (such as college for your offspring, a legal dependent, or even yourself)
- Payments made by you to ward off eviction or foreclosure
- Repair damage to your principal residence after certain casualty losses (watch this closely; Congress is considering loosening these restrictions further in the wake of hurricanes Harvey and Irma)
- Burial/funeral expenses of a parent, spouse, child, other dependent, or your plan’s beneficiary
- You terminate employment — that is, you retire, or are forced into retirement — and are at least 55 years old
Again, you shouldn’t eye your 401(k) unless you have exhausted all other alternatives.
In fact, your plan could contain a provision that allows withdrawals only if you can demonstrate “heavy and immediate” financial need, and you are otherwise without resources to draw upon. That is, you cannot borrow from a commercial lender or a retirement account.
401(k) Withdrawal: An Example
Let’s look at a scenario. Susie piles up credit card debt due to a combination of poor money management and bad luck (reduced income from an illness). Her 401(k) has enough money saved to get her out of debt and fast. By withdrawing $15,000, she’ll be able to completely pay off her credit cards and start fresh. This sounds like a good idea, so goes ahead and contacts her account manager and requests the check. Susie has $25,000 saved, so she expects that her distribution, or early withdrawal, will leave her with a bout $10,000 in her retirement.
Unfortunately 401(k) withdrawals are taxed at your income tax rate plus an additional 10 percent penalty. Since Susie pays a middle class federal tax rate of 25 percent, she’ll have to pay 35 percent to the federal government for this withdrawal. That’s $5250. Her $15,000 loan is going to cost her $5250 to access. That means, after her withdrawal, her 401(k) will be reduced to $4250.
But that’s not all that Susie has lost. That $25,000 grows at an average annual rate of 8 percent, per year. Since she is 35, the money has 30 years to grow. If she never adds another dollar to her account, and continues to achieve 8 percent growth, she can expect to have a quarter of a million dollars in her account by the time she’s 65. Yes, that $25,000 will grow 10-fold in the next 30 years. If she withdraws $20,250 to pay off her credit card debts and is left with a balance of $4250 which grows at the same rate for 30 years, she’ll have nearly $48,000 in her account at retirement. So this 401(k) distribution or withdrawal will cost her the initial $5250 in taxes and an additional $200,000 in lost growth over time.
Pros and Cons of Taking a 401(k) Early Distribution
- Pro: Easy way to pay off debt quickly.
- Pro: Money is available quickly (often within a few days).
- Pro: Unlike a loan, money from a 401(k) is your money and does not have to be repaid.
- Con: Expensive tax penalty: your federal income tax rate plus 10%
- Con: Lost growth over time – from now until you retire
- Con: If you don’t change your habits, cashing out your 401(k) could lead to you re-acquiring the same debt. If you cash out your retirement account to pay credit cards, make sure to close most of them after they are paid off.
Alternatives to 401(k) Distributions
Principal Financial Group’s head honcho Larry Zimpleman notes, “allowing limited access to loans and hardships is an important incentive for people to voluntarily enroll in a 401(k) plan and feel comfortable about deferring higher amounts of their pay.”
After all, enrollees are sacrificing one immediate good (extra take-home pay) for a future, less-tangible one (a more comfortable retirement). Allowing narrow backdoor access to that money encourages savings that might not otherwise happen.
But, again, exhausting every alternative is crucial to your future security and happiness. Especially if you are considering withdrawing from your 401(k) to reduce or eliminate high-interest debt, here are some alternatives you absolutely must consider:
- Negotiate your current interest rate with your credit card company. If you have good credit, you could trim your rate by several percentage points.
- Making extra payments will shrink the interest charged and shorten the length of the loan.
- Are you wrestling student loans? Try consolidating them with other loans at a better rate. If your credit score has improved since you initiated the loan(s), check out online lenders for refinancing.
- Investigate a personal loan, unsecured or collateralized, to consolidate your debt at a lower interest rate.
- Liquidate assets, such as jewelry, that third big-screen TV in the breakfast room, a portion of your non-retirement portfolio, like a boat unused car.
- Take a second, part-time job.
- Can you stop contributing to your 401(k) and use the extra money in your paycheck to make payments on your debt?
If, on the other hand, you’ve left the job where you had a 401(k) and you’re wondering what to do now, consider your IRA options.
A traditional rollover protects your retirement savings from taxes and penalties. Act expediently; there are time restraints. Or you could roll it into a Roth IRA. You’d pay income taxes upfront, but, according to Fidelity Investments, avoid the penalty. When retirement comes, you’d tap the growth portion tax-free.
Additional alternatives: Leave your old 401(k) alone. Many employers won’t fuss about your 401(k) staying in the fold even after you have departed. Or, if you’ve moved to a company with a 401(k) program, you could roll your old fund into your new one.
Things to weigh when contemplating rollover options:
- Fees and expenses
- Investment options
- Liquidity and security
Almost 11% of workers with 401(k) plans took out a 401(k) loan in 2015, and the average amount was $9,500.
You can borrow up to 50% of your vested savings, up to $50,000. There are occasions when a 401(k) loan makes sense, such as paying off high-interest credit cards with a lower-interest loan. But almost every credit counselor since Ponticus’s days will tell you the cons outweigh the pros.
The beauty of a 401(k) is your contributions aren’t taxed until the money is withdrawn, and interest rates are relatively low. So the money you borrow isn’t taxed as long as you pay it back on time.
But you’ll use after-tax dollars to pay the interest, which is deposited back into the account. Then you’ll be taxed again on that money when you tap into your account after retirement.
The danger comes if you become unemployed or otherwise can’t repay the loan. You have 60 days to repay the loan if you lose your job. If you default, that loan becomes a distribution and you’ll pay taxes on the entire amount as well as a 10% penalty.
The whole point of a 401(k) is to defer taxes on your contributions and let the money grow tax-free. You can begin withdrawals without penalty at age 59 1/2. The theory is that you’ll be in a lower tax bracket in retirement, so you’ll be paying lower taxes on all that money you saved over the years.
The strategy only works if leave the money alone. It’s deposited in mutual funds and other investment options, so the rate of returns varies with the economy. But in general, 401(k) participants can expect a 5%-to-7% return.
In real terms, if an employee deposited $10,000 at age 30 and got a 6% return, it would turn into $17,908 in 10 years, $32,071 in 20 years and $57,435 by the time the employee turns 60 and is ready to head to Florida.
Even more drastic is the effect of cumulative deposits. Fidelity Investments manages 401(k) accounts for 13 million employees in 20,000 companies. It noted the stark difference between two 25-year-old employees, each earning $50,000 a year who defer 10% annually in a 401(k).
Employee A doesn’t touch his deferrals and at retirement has a nest egg of $537,000. That works out to $2,650 a month in retirement income.
Employee B takes out a loan that is repaid. But he stops contributing to his 401(k) for 10 years, then resumes deferring 10% of his income.
That gap will reduce his retirement fund to $396,000, or $1,960 a month. That’s $690 less than Employee A, which will pay for 16 ribeye dinners at Ruth’s Chris Steakhouse, not counting the tip.
At 16 cents per 3-ounce serving, it would also buy 4,058 helpings of Ramen beef noodles from Walmart. But who wants to work hard for 40 years just to slug down beef-flavored soup for dinner?
Another plus is that 401(k) funds are protected in bankruptcy proceedings. Nobody likes to the think they’ll end up there, but the fact people even consider tapping into their retirement funds often indicates they might need to overhaul their financial habits.
A Fidelity study showed that from 2007 to 2013, 24% of borrowers decreased their savings rate in the first year after a loan was taken, and 9% stopped saving altogether. Within five years, 40% of borrowers had reduced their savings rate from pre-loan levels, and 15% had stopped savings altogether.
That may not be a recipe for disaster, but it is a recipe for Ramen noodles. Before taking that step, it pays to investigate debt-relief alternatives. A non-profit credit counseling agency like InCharge can take a comprehensive look at your financial situation and offer free advice on how to eliminate your debt without raiding your retirement.
Debt Management Program
Many consumers enroll in debt management programs, where their bills are consolidated and they make one monthly payment to the credit counseling agency, which distributes the funds to creditors. With a debt management program, you’ll be able to achieve a lower monthly payment on your credit card debt, and lower interest rates. By leaving the money in your 401(k) alone and letting it grow, you’ll pay off your debt and see growth in your retirement plan.
It’s not as easy as simply loaning yourself money. You’d have to give up credit cards. That alone would make many consumers would feel as if they’d joined a monastery.
But take it from our old monk friend Evagrius Ponticus. Getting a 401(k) loan may not be one of the Seven Sins. But giving into that temptation can be deadly to your retirement.
Withdrawal Without Penalty
We touched on this above. But it bears revisiting. If, after all, you must tap your 401(k), make certain it is only under penalty-free conditions. These include:
- Burial and/or funeral expenses
- Relief from certain disasters
- Some higher-education expenses for dependents or yourself
- Funding the purchase of a first (but only a first) house
- You have been declared disabled by a qualified source
- Emergency medical bills (with certain restrictions)
You are 55 or over and, for one reason or another, your working days are over: You choose to retire early, or you lose your job and are unable to find suitable work.
Extended Lifespan as a Factor
Despite dire warnings about the overall track of life expectancy in the United States (it’s flattening, according to a World Health Organization report from early 2017, but that report might not be all it’s cracked up to be), the important consideration — for purposes of weighing a 401(k) withdrawal — is how long you can expect to live in retirement. For this, we turn to our friends at the Social Security Administration, which provides this encouraging news:
A man who reaches the age of 65 can expect to live, on average, until age 84.3. Women do even better. Those who make it to 65 can expect to cruise, on average, all the way to 86.6.
Those are averages. Social Security also notes that about one in four 65-year-olds today will live past age 90. One in 10 will live past age 95.
In short, if you make it to retirement, you’ll still have a lot of living to do. And living takes money. Living well takes plenty of money. Consider that before you compromise your future with a hasty, penalty-laden distribution during your working years.
You always have access to the money you have invested in your 401(k); under some circumstances, you also can tap your employer’s matching contributions. But in all but some limited, specialized cases, you’ll hit a wall of IRS penalties and taxes.
The best long-term advice is to follow the five rules listed near the top: Invest hard, follow your plan, and, as the Beatles sang, let it be.
But if you must de-feather your nest egg, make certain the reasons are sound, and that you have a solid plan for restoring as quickly as you can what you had to spend. You don’t want your 70-something years thinking you were some dopey kid back when you raided the old 401k. That’s your parents’ job.
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