For many Americans, their 401(k) plan is the largest single pool of money that they own. Thus, it’s somewhat understandable that some view it as a source of funds when they encounter a financial need. But withdrawing or even borrowing money from your 401(k) should be a move of absolute last resort.
Besides sacrificing your financial future, taxes and penalties on early 401(k) plan withdrawals can exceed 50% in some states for those with high incomes. Yet, a recent study from the Transamerica Center for Retirement Studies found that a whopping 37% of Americans have nevertheless taken an early withdrawal, loan or hardship withdrawal from their retirement savings, an all-time high. What are the reasons that would push someone to raid their retirement savings, and is it ever the right move to make?
Why Americans Are Raiding Their Savings
Looking at the results of Transamerica’s study optimistically, not many Americans are draining their retirement savings just to go on spending sprees or for other discretionary purposes. Rather, most are facing actual financial emergencies or needs, such as staving off eviction or covering medical or disaster expenses. But this of course raises another important question: Why are Americans in such difficult financial circumstances that they feel they have to raid their retirement accounts?
The bottom line is that a lot of Americans have little-to-nothing in their emergency funds, and their debt levels are increasing. This is likely due to a combination of factors, ranging from high inflation and interest rates and lingering effects of the pandemic. This makes them more susceptible to withdrawing from any source of funds available, including their 401(k) plans.
What Are the Consequences?
The consequences of premature retirement plan withdrawals are significant. With the exception of Roth accounts, any money you take out of a traditional 401(k) before age 59.5 is subject to ordinary income taxes. Additionally, with few exceptions, you’ll face a 10% early withdrawal penalty. Between federal and state taxes and the early withdrawal penalty, you may have to fork over 50% or more of your withdrawal.
However, the long-term consequences of an early 401(k) withdrawal may be even more damaging. It takes time for compound interest to work its magic and significantly boost your 401(k) balance, so taking money out essentially returns you to square one. To help visualize the long-term effects on your nest egg, think of how much the money you are withdrawing now will be worth after you retire, rather than its current value.
For example, while you might think that withdrawing $10,000 from your 401(k) right now isn’t a big deal, imagine if that amount were left to grow in your account. After 20 more years, earning 8% interest annually, your $10,000 would have grown into nearly $50,000. Viewed through that lens, that’s a significant loss.
When it comes to loans, you can typically borrow the lesser of $50,000 or 50% of your vested account balance, although not all employers allow them. The advantages a loan has over a distribution are numerous. Loans are not considered withdrawals, so they have no tax consequences. Additionally, the interest you pay on the loan goes directly back into your own account, so you’re not paying a bank or lender.
However, it’s essential to understand the downsides of loans also. While that money remains out of your account, you’re missing out on investment returns. If you’re somehow unable to pay back your loan, it will also become a taxable distribution, with the same consequences — including early withdrawal penalties — as a withdrawal.
Is It Ever the Right Move?
Taking a premature distribution from a 401(k) plan is truly a step of last resort. Since both the immediate and long-term effects can be so damaging, it’s best not to view your retirement plan as a type of supplemental emergency fund.
Of course, if you literally have no other options for cash and are about to be thrown out on the street, then yes, you might want to consider a hardship option. But it’s important to understand all of the consequences before you make such a potentially life-changing choice. While taking a 401(k) loan is a slightly less consequential option, it’s still not ideal, as outlined above.
What Are Some Alternatives To Disrupting Your Retirement Savings?
The best way to avoid dipping into your 401(k) plan prematurely is to plan ahead. Nearly everyone will face one or more financial emergencies in their lives, so rather than waiting for it to happen, be proactive. Here are some steps you can take to avoid an early withdrawal:
- Steadily and consistently contribute to your emergency fund.
- Budget for easily anticipated emergencies, such as car repairs, medical bills and home repairs.
- Contribute to a Roth account, so in a real emergency, you can withdraw your contributions tax-free.
- Consider using a 0% credit card to fund short-term expenses, with the caveat that you must know that you can pay that money back before the end of the promotional period.
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