There may be times in life that you’ll fall into financial hardship, and it’s wise to plan ahead for the inevitable. An emergency fund — that is, a generous amount of cash in your savings or another account — is ideal for dealing with these situations, but that’s not always realistic. It stands to reason that if you’ve fallen on hard times, you’re likely tapped out on liquid assets, forcing you to look elsewhere for additional funds — and a lot of times that place is your 401k.
While prematurely digging into your retirement savings isn’t recommended, it is sometimes necessary. If that’s ever the case for you, here are four things to be aware of to help you make the best of it:
Consider Your Other Retirement Accounts First
“If one must withdraw money from a retirement account, it’s usually best to withdraw from a Roth IRA,” advises Rob Drury, executive director of the Association of Christian Financial Advisors. “The reason for this is that one can withdraw up to the full principle amount — the total amount deposited into the account by the investor — without penalty or taxation. This is because the Roth IRA allows only for post-tax contributions.”
Stop and Think, Is This the Last Resort?
Even if you don’t have a Roth IRA as an alternative source of financial security, there are other ways to avoid your 401k, first by asking yourself if this situation is dire enough to create more debt in trying to deal with it.
“Occasionally, people have to dip into retirement funds in response to a genuine emergency,” Drury points out. “Unfortunately, more often the situation does not constitute an absolute necessity. Retirement accounts are often the only significant savings an individual has, so they’re an easy target when one sees a need for a sizable sum of money.”
As an alternative, ask your bank for a personal loan — which may or may not work in your favor, depending on how deep you’re in debt — or maybe even family or friends. The interest rate for borrowing from any of these sources will certainly be less than the fees you’ll rack up by borrowing from your 401k.
Consider Taking a Loan Out Against Your 401k
If you’re in a financial pickle, you can make a hardship withdrawal from your 401k — but there’s a better option many people may not know about: many funds allow you to take a loan from your 401k.
“By exercising this option rather than a straight withdrawal, you may be able to accomplish the same goal, but without having to pay the penalties and taxes,” says Vic Patel, professional trader and founder of Forex Training Group. “Keep in mind, though, that you must repay the proceeds in order for it to quality as a loan and not an early withdrawal.”
“A 401k loan carries no penalty or tax, as it is a loan rather than a distribution,” Drury adds. “One must keep in mind, however, that should one’s employment end – even involuntarily – before repayment of the loan, the unpaid portion becomes a distribution for tax purposes. The IRS considers it ordinary income, and it will incur the 10% penalty if the individual is younger than age 59 and a half.”
Prepare to Take Another Hit to the Wallet When Dipping Into Your 401k
In the case of most tax-deferred retirement vehicles, including annuities, there is a 10% penalty on any withdrawals prior to age 59 and a half. If the account is a pre-tax qualified account, such as a 401k or Traditional IRA, one also pays ordinary income tax on the entire withdrawal. Translated into mathematical terms, if you’re in the 24% tax bracket, that total cash out will cost 34%, perhaps much more than you originally anticipated.
Photo Credit: bernadette macpherson morris
Nice post, Len! Thanks.
It is important to really consider if it is your only option as cashing in your 401K may cause a big penalty. Great information, thanks for sharing!