It can be a struggle when you suddenly have a need for extra cash – especially in our current economy and the stressors of the pandemic. If you've built yourself a nice emergency fund, you may be able to draw on it to cover your needs. But what if you need to look elsewhere? What if you find yourself looking to tap into your 401(k) earlier than you had planned?
First, some alternatives:
If it’s at all possible to avoid taking money from your 401(k) before you’re retired, you should generally try to do so. You could spend two, or even three, decades in retirement, and you’ll likely need the financial resources to pay for those years. To avoid taking money from your 401(k), we recommend you first take the following steps:
- Start by reviewing your budget for opportunities to reduce or reallocate spending. There may also be assistance programs to help cover expenses.
- If you don't have enough cash on hand to meet your expenses and you’ve built the aforementioned emergency fund, you may be able to draw on it to cover your short-term needs.
- Next, consider selling investments in taxable accounts, drawing first from cash in the account, then investments with losses, and lastly, investments with gains.
If these solutions don't fully meet your needs and you’ve determined you must tap into your 401(k), be sure to know your options. Depending on the terms of your plan, you may have two options while still employed: loans and withdrawals.
With a 401(k) loan, you borrow money from your employer retirement plan and pay it back over time. (Employers aren’t required to allow loans, and some may limit loan availability to paying for medical or educational expenses, or for the purchase of a first home.) Although employers have different rules regarding loans, you can generally borrow up to 50% of your vested amount, up to a maximum of $50,000 within a 12-month period.
401(k) loans typically don’t require a credit check and won’t count against your credit score. The money you borrow is tax-exempt, as long as you repay the loan on time, so you generally don’t have to claim the loan on your tax return. You'll likely incur administrative fees and you’ll be charged interest, but the interest will be paid back to your account as part of your repayments.
While you’re employed, you generally have five years in which to repay your loan and must make payments at least quarterly. If you're unable to make timely payments, your loan will be considered in default, and the entire outstanding balance of the loan will typically incur taxes and potentially a 10% penalty if you're under age 59½. The outstanding balance also can't be rolled back into the plan or to an IRA when you default on a plan loan.
If you leave your employer before the loan is fully repaid, the due date for your loan is typically accelerated, and many plans will immediately treat the outstanding loan balance (including accrued interest) as a distribution. However, since the distribution is due to separation from employment (instead of default), you can roll over the amount of the loan balance to an IRA to avoid any taxes and penalties. You also have longer than the usual 60-day rollover period to do so. Instead, you have until the due date of your tax return for the year in which the distribution occurred. So, for example, if the distribution occurred in 2022, you’ve got until the tax filing deadline of April 18, 2023 (or a few months later, if you get an extension on your taxes), to roll over the amount of the loan balance. Any amount not rolled over by that date, including accrued interest, will typically be subject to taxes along with a 10% penalty if you’re under age 59½.
A few things to consider:
A 401(k) loan can work against you in a couple of ways. First, the loan, by definition, has taken out money from your 401(k), so you have less money working for your retirement for a period of time, although this is somewhat offset by the interest you earn on the loan. And second, your employer may limit your new contributions to your 401(k) while the loan is outstanding. Even if contributions are not limited, you may not be able to afford to make both loan repayments and contributions at the same time. Lower contributions could affect your ability to receive employer matches – ultimately resulting in a lower account balance than you might have had without the loan. That being said, if you're fairly confident you can pay back the loan and it won't impact your ability to make contributions, a plan loan may be preferable to selling investments in your taxable account.
Like loans, not all employer plans allow you take withdrawals while still employed, also known as in-service withdrawals. Depending on your plan, there are two types of in-service withdrawals that may be offered: hardship withdrawals and non-hardship withdrawals.
To qualify for a hardship withdrawal, you must have an immediate and heavy financial need, and the amount of the withdrawal must be necessary to satisfy the financial need. Your plan may require certain documentation from you, but expenses that generally qualify as an immediate and heavy financial need include:
- Costs related to the purchase of your primary residence, payments to prevent eviction from or foreclosure on your primary residence, and certain expenses to repair damage to your primary residence
- Tuition and related educational fees and expenses
- Certain medical expenses
- Burial or funeral expenses
Hardship withdrawals cannot be rolled back into the plan or to an IRA.
Non-hardship withdrawals can generally be taken for any purpose but are typically limited until age 59½ or later. Only certain types of contributions, such as profit sharing and employer matching contributions, can be distributed prior to age 59½ (if permitted by the plan). Unlike hardship withdrawals, non-hardship withdrawals can be rolled over within a certain time limit, typically 60 days.
A few things to consider:
Unlike a loan, taking a withdrawal from your 401(k) significantly limits your ability to repay yourself – hardship withdrawals can't be repaid at all and non-hardship withdrawals can generally only be repaid by rolling over the amount taken within 60 days. You could try to compensate by increasing your annual contributions if you aren’t already hitting the maximum.
Perhaps an even bigger drawback is the tax burden. Generally, if you withdraw funds from your 401(k), the money will be taxed at your ordinary income tax rate, and you’ll also be assessed a 10 percent penalty if under age 59½ unless you qualify for an exception. Additionally, your plan typically must withhold 20% of the withdrawal for taxes, which may require you to take a larger withdrawal to meet your needs. Taken together, these taxes and penalties can make withdrawals pretty expensive.
Review options carefully – and get help
Facing a temporary money crunch is not uncommon. But if it happens to you, think carefully about your options before turning to your 401(k). And if you do decide that you must tap into this account, learn everything you can about how it will affect your retirement planning and tax situation. Talk with your financial advisor and a tax professional about it so you can be better prepared to make the right choices.