Dipping into your 401(k) while you’re still working seems like an easy source of money. Don’t do it! You are borrowing against your future financial security.
So you’re socking away your hard-earned money in a 401(k)– that’s great. But what happens if you suddenly need the money NOW? It’s your money, you say, you should be able to tap into it.
WARNING: Taking money out of your 401(k) is dangerous to your financial health. You’ll pay high penalties and, worst of all, reduce the growth of your nest egg. You’ll pay dearly in the future for the cost of those lost savings.
Here are the hard facts. There are two main ways to get your 401(k) money out while you’re still working:
These are reserved for cases of what the IRS calls “immediate and heavy financial need.” Check your own plan to see what qualifies as a hardship. It may include situations such as the purchase of a primary residence; medical expenses; disability; college tuition for you, your spouse or children; or payments to prevent eviction or foreclosure. The IRS has strict rules about withdrawals. You will likely have to prove this is the only money available to you. For more info, go to the IRS site
Withdrawals come at a high price. If you are under 59 ½ years of age, you will in most cases have to pay an early withdrawal penalty of 10% on any money you take out. No matter what your age is, you will also pay your normal income tax rate on the money you withdraw. Another big drawback: Your 401(k) account will now be smaller, so you lose out on potential growth of your money. That can mean a significantly smaller nest egg at retirement time.
Not all employers allow withdrawals. Check with your summary plan description (the rules for your company’s plan).
Most 401(k) plans allow you to borrow money from your account. Some plans allow loans only for specific situations, which may include buying a home, medical expenses or college tuition. Each plan has limits on how much you can borrow: in general, no more than 50% of the account’s value, up to $50,000 maximum.
You will pay interest on your 401(k) loan at a rate determined by your plan, usually 1 to 2 percentage points above the prime rate (the interest rate charged by banks to their best customers). The interest you pay goes back into your 401(k) account. The loan typically must be repaid within five years. If you are borrowing to buy a home, the repayment period can be longer. The loan payments will be taken out of your paycheck after taxes are deducted. When you retire and take out the money, you will pay tax on it again – yes, you are being taxed twice on money you borrow! And unlike a home equity loan, you won’t get a tax deduction on interest you pay.
If you leave your job, the loan is due immediately. If you are unable to repay the loan, the loan is considered a cash withdrawal, so you’ll have to pay income tax on it – and the 10% early withdrawal penalty if you are under age 59 ½.
Taking a loan slows the growth of your 401(k) money if you can’t keep making your regular 401(k) contributions while repaying the loan. And if you stop making contributions, you will lose your employer match – a double hit to your nest egg. *