If your budget is tight and you are tempted to use your 401(k) plan as an ATM, you should know the consequences of using your retirement funds early. While it may seem to be a viable option for you, it may not necessarily be the right decision. More than 30% of 401(k) investors choose to cash out before 59½ and lose out on significant tax savings whereyou can make withdrawals without inviting a 10% early distribution penalty over and above the income taxes you owe.
According to a recent study conducted by the Employee Benefit Research Institute, more than 20% percent of 401(k) investors have outstanding loans against their retirement accounts and the average due exceeds $7,000.
401(k) plans were not designed to function as an emergency reserve. However, if you are compelled to use it as an ATM, experts suggest you to stay cautious in the following situations:
Loans seem to be an easy and enticing option when people are financially strapped. However, if your company provisions allow you to take a loan against your retirement reserve, you get to borrow your own money and pay it at a later date with interest. While you may foresee no financial harm as these loans do not invite any tax liabilities or penalties, you may not be aware of the fact that:
Depending on your retirement funds for a loan can get you banned from contributing to your 401(k) plan for the next six months.This means that you won’t be able to make any pretax contributions and this leaves no scope for you to lower your gross income which will trigger a higher tax bill for the year-end. Your one wrong decision will set off a series of unwanted liabilities.
Is Your Budget Prepared To Take The Burden Of Target-Date Funds?
Loan payments are not only long-term but also requireafter-tax dollars. When you take a loan against your 401(k) plan, you are already in a cash crunch. This can get worse for you if for any reason you lose your job. Your long-term loan becomes due in an instant and if you are unable to pay the balance amount, it triggers an early distribution which is subjected to a penalty of 10% apart from income tax. Take a loan only if you know that your job is secure for the coming five years. Here is a real-life illustration to help you understand things better –
A smart employee earning a six-figure salary needed a cash loan to support to his high-end lifestyle. He took a the maxiumum loans amount of $50,000 against his 401(k) plan to fund his $1 million-plus home not awar of the fact that he will soon lose his job. Now he owes more than $15,000 in taxes apart from the interest on a $50,000 loan. He might have to use all his retirement savings yet again to fund his liabilities.
Change of Job
Most early withdrawals happen when people under 40 switch their jobs. While certain employers allow you to keep the money even as you move on to your next job, others may remove you from the plan if your 410(k) balance is low. You receive a check which should ideally be rolled into an IRA but many are tempted to cash it out and this invites an instant tax hit of 10% penalty plus income tax.
Compelling Reasons to Not Borrow from Your 401(k) Plan
Opting for cash out would invite an early distribution penalty along with income taxes. You would be left with little cash after paying up your penalties and taxes.
Circumstances under Which You Can Avoid a Penalty
Certain early withdrawals do not invite a penalty. A qualified domestic relations order allows the recipient to withdraw the money and use it to settle the dues in a divorce. When the ex-spouse is entitled to your 401(k) plan, the withdrawal amount is not subjected to a 10% penalty.
However, a court ordered QDRO does not mean you can easily split up your retirement savings.If you are not left with any liquid assets and this is the only option, you can hire an experienced attorney to draft the order on your behalf. You also need to have it approved and accepted by the court as well as your 401(k) administrator.
There is another rule that exempts you from tax penalties and it is popularly known as the – Age 55 Rule. According to this rule, if you leave the workforce after your turn 55, you are eligible to take a distribution from your retirement fund without inviting a penalty. This rule is only applicable to the company where you turned 55 and gave up your employment voluntarily. A former 401(k) plan at a previous employer does not qualify under this provision until you turn 59½.
One more exception is the 72(t) distribution, wherein you are entitled to penalty-free periodic withdrawals on a predetermined amount. You can make these withdrawals from your 401(k) plan till you turn 59½.
Contemplating a Job Change? Be Sure To Avoid This Big Mistake!
If you plan to take a hardship distribution for emergency expenses, you cannot escape the penalty. Your 401(k) funds should be your last resort when it comes to funding your pre-retirement problems.
These points are well worth considering if you are planning to use your 401(k) funds.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He brings over 30 years of diverse experience as a financial advisor. Rick takes great pride in giving honest and very experienced advice. Rick can readily converse with business owners and people looking to take control of their retirement accounts.