Why $1K From Your 401(k) Beats High-Interest Debt: New Penalty-Free Option Explained
Written by
Heather Altamirano
Edited by
Rebekah Evans
Commitment to Our Readers
GOBankingRates' editorial team is committed to bringing you unbiased reviews and information. We use data-driven methodologies to evaluate financial products and services - our reviews and ratings are not influenced by advertisers. You can read more about our editorial guidelines and our products and services review methodology.
20 Years
Helping You Live Richer
Reviewed
by Experts
Trusted by
Millions of Readers
Most people know the sinking feeling that comes with an unexpected expense. Whether it’s a car problem, a medical bill or a costly home repair, a surprise can quickly drain your bank account. Having three to six months of savings to cover unforeseen costs is the general recommendation from financial experts, but for many, that isn’t the reality.
According to an Empower study, more than one-fifth (21%) have no emergency fund, while a CreditOne Bank survey found that more than half (51%) rely on a credit card to cover a $500 emergency expense.
To help ease financial burdens, a provision in the Secure 2.0 Act allows people with a 401(k) to withdraw up to $ 1,000 penalty-free for emergency expenses. Here’s how it works.
Emergency 401 (k) Withdraw Rules
Instead of turning to high-interest credit cards, some savers now have another option. The rule applies to the following.
- Roth-style pension-linked emergency savings accounts (PLESAs), per the Bipartisan Policy Center Action.
- A company must offer this option and an employee must be enrolled.
- You must pay taxes on the amount withdrawn, according to ABC 5 Eyewitness News.
- A withdrawal of up to $1,000 per calendar year for emergencies, per Nationwide Insurance.
- Only one withdrawal per three-year repayment period is permitted if the first withdrawal has not been repaid, according to AARP.
A 401(k) Withdrawal vs. Credit Card Debt
Driving up credit card balances can be costly with interest rates, so this option can help avoid mounting debt in some cases.
“Credit cards carry APRs upwards of 20%, which can easily trigger a spiraling debt cycle,” said Yehuda Tropper, CEO of Beca Life Settlements. “This rule lets you access cash without incurring those exorbitant interest rates.”
But if it’s doable, paying off a credit card in 30 to 60 days is the better choice, according to James Comblo, partner at Prosperity Capital Advisors.
“The interest is minimal and your retirement savings stay intact,” he said.
Well-Intentioned Rule With Drawbacks
In certain situations, a 401(k) withdrawal helps reduce financial strain, but there’s a major red flag, according to experts.
“I worry it normalizes tapping retirement savings for expenses that a proper emergency fund should be covering,” Comblo said.
He’s not the only expert who warns of caution when it comes to withdrawing from your retirement account.
“The hazards of taking money from your 401(k) limit your options later in life,” said Robert Johnson, Ph.D., chartered financial analyst (CFA), chartered alternative investment analyst (CAIA) and professor at Creighton University,
“If one uses a 401(k) as a piggybank, one will accumulate less money in a 401(k) and when retirement comes, one will be left with a stark reality,” he explained.
High-interest debt can derail long-term wealth building. With that in mind, the emergency withdrawal is a helpful resource, but only if it’s not abused.
“It can hurt your compound growth,” Tropper added.
More From GOBankingRates
