In the case of a financial emergency, you might have to dip into your 401k plan to find the money you need. This is never an ideal scenario, as taking money out of such accounts can severely set back progress you’ve made in saving for retirement.
However, desperate times call for desperate measures. Maybe you want the money for a new business. Or perhaps a family member needs some help. Paying off high-interest loans is also a common reason people cash out early. Whatever the reason, you can choose to either withdraw the money outright and pay a hefty 10% penalty, or borrow the money from your own account.
Neither scenario is ideal, yet there are pros and cons to each option. Depending on your situation, one of these might make a lot more sense than the other.
Withdrawing the Money
The easiest route to take is to withdraw the money that you’ve saved in your 401k. Although this is a simple route that can give you much-needed access to capital, the penalties are severe for withdrawing before you reach retirement.
For starters, you’re hit with a stiff 10% penalty. As if that isn’t enough, taxes add insult to injury — the money you withdraw counts as income. Depending on how much you earn and how much you withdraw, you’re probably paying at least 10% of the money in taxes.
Before you know it, a good chunk of the money you took out is gone. It seems unfair, but 401ks were designed with certain tax advantages in mind, so if you cash out early then you’ll have to pay the penalty.
Taking Out a Loan
Once you withdraw the money, it’s gone for good. You can make up for the withdrawal by increasing your deposits in the future, but it’s an uphill battle and it’s tough to get back on track. That’s why it might make more sense to borrow money from your 401k. Around 87% of 401ks offer this loan option. If your 401k doesn’t offer this, then you’ll have to settle with making an outright withdrawal.
So what happens when you take out a loan to borrow what’s essentially your own money? The details vary case by case but, if you’re employed you’ll normally have five years to pay back everything that you took out. However, if you lose your job during this period, you’ll only have a couple months to repay the outstanding loan in full — if you don’t, you’ll be subject to the early withdrawal penalty.
Those are stringent requirements, but a loan can really work out in your favor if you’re stably employed and able to make the repayments. The impact will be far less on your long-term retirement savings than if you made the withdrawal.
Penalty-Free Withdrawals
Normally, you have to reach a certain age before withdrawing your money without paying a penalty. However, there are some specific cases where you can withdraw the money with zero penalties. For example, the money can be withdrawn penalty-free in the case of unpaid medicals bills, divorce and other situations.
These exemptions might be exactly what you need. While it’s still money that won’t be there for your retirement, it might make sense to dip into the account in order to handle more pressing issues. To see what sort of impact your decision can have on your long-term retirement prospects, play around with this retirement calculator.
Regardless of which route works best for you, think long and hard about taking any savings from your account before pulling the trigger. It’s a big decision that shouldn’t be rushed.
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Anum Yoon is personal finance blogger who started and maintains Current on Currency. You can catch her on Twitter to follow her updates.
Photo Credit: urban_data
It’s way better to take a loan. At least it’s pretty certain that you will have to pay yourself back. The early withdrawal is something that is impossible to undo basically.