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Alternatives to Early 401(k) Withdrawal

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Taking money out of a 401(k) plan before you reach retirement age carries a steep penalty. It's best to evaluate the costs and consider alternatives to an early 401(k) withdrawal.

couple-discussing-loanIt's hard to find money in your budget month after month for retirement savings.

But when an unexpected financial need comes up that creates an immediate demand for funds, it's tempting to pull money out of your 401(k) plan and move on.

There's a steep price to pay, though, and it's not just the early withdrawal penalty.

Before you go this route, you should understand the costs and consequences of this decision. The good news is, there are some alternatives to withdrawing from a 401(k) plan early.

Why There is a 401(k) Early Withdrawal Penalty

When you put money in a 401(k) plan, the amount of that contribution is excluded from your taxable income in the year the contribution is made.

However, the government doesn't give this tax break for nothing. It expects that 401(k) contribution to remain untouched until you reach normal retirement age.

Normal Retirement Age

For most retirement-planning purposes, normal retirement age is considered to be age 59 1/2.

If you take money out of a 401(k) plan before age 59 1/2, you have to pay a 10% penalty on the amount you withdraw.

The penalty is meant to discourage people from undermining their ability to make progress toward retirement. For many people, it's only by adding to the pot year by year over their working careers that they have a chance to accumulate enough money to retire.

A 10% penalty is harsh enough to drive that point, but it is not the only cost of withdrawing from your 401(k) early. There are direct and indirect costs that come into play.

Direct Costs of an Early 401(k) Withdrawal

There are two ways withdrawing from your 401(k) early will cost you:

  1. Early withdrawal penalty
  2. Ordinary income tax

Early withdrawal penalty

Unless you qualify for an exception to the 10% early withdrawal penalty, expect to pay the early withdrawal penalty immediately. And the withdrawal may be subject to your company's 401(k) plan rules as well.

Ordinary income tax

The way 401(k) withdrawals work, even if you take the money out after reaching normal retirement age, you have to pay tax on it.

Theoretically, though, you would be in a lower tax bracket by the time you retire at that age.

But there's another direct cost in addition to the 10% tax penalty when you make an early withdrawal from your 401(k). You will also have to pay the ordinary income tax on the amount of the withdrawal. (This is to make up for being able to avoid paying tax on that money when you originally put it into the plan.)

The danger is that you could be in a higher tax bracket if you make an early 401(k) withdrawal in your peak earning years and you might subject yourself to a higher tax burden.

Between income taxes and the early withdrawal penalty, for most taxpayers, you would get to keep less than 70 cents out of every dollar of 401(k) money you take out early.

Indirect Costs of an Early 401(k) Withdrawal

The 10% penalty and immediate taxation are direct costs on early 401(k) withdrawals. However, there are also indirect costs to these withdrawals.

  1. Lost opportunity to reach contribution limits
  2. Lost tax-free investment growth

Lost opportunity to reach contribution limits

There are limits on how much money you can put into a 401(k) plan each year.

For example, in 2019, the limit on 401(k) contributions was $19,000.

If you withdraw money from the 401(k) plan rather than put money in during a given year, you will miss the opportunity to contribute up to that year's withdrawal limit to the plan.

Even if you had the means to contribute twice the limit the following year, the tax break would only be available up to a single year's limit.

Lost tax-free investment growth

The deduction on 401(k) contributions is not the only tax benefit these plans offer. Once your money is in the plan, any investment earnings grow tax-free until you withdraw that money.

That gives you the extra benefit of allowing your investment gains to compound free of taxation. Take the money out early, and you could lose several years of this benefit.

Alternatives to an Early Withdrawal from a 401(k)

Given the costs of an early withdrawal from a 401(k) plan, it is well worth thinking through the alternatives:

  1. Borrow from your 401(k) plan
  2. Home-equity loans and personal loans
  3. Hardship withdrawal
  4. 403(b) and 457 plan exemption

Borrowing from your 401(k)

Some 401(k) plans allow you to borrow against your plan balance. This is dependent on the rules your employer has written into their 401(k) plan, so you can't assume this option is available to you unless you check.

Even if you can borrow against your 401(k) plan, there are pros and cons to consider before you take this action.

  • On the plus side, your subsequent loan repayments won't count against your 401(k) contribution limit, so the total amount you are allowed to put into your 401(k) plan over time won't be diminished.
  • On the downside, though, you will be missing out on potential tax-deferred investment gains for as long as the money you borrow is out of the plan.

Even worse, many companies have rules that require 401(k) loans be repaid immediately upon an employee's departure from the plan. This means, if you leave or lose your job, you will be required to come up with enough cash to repay the loan right away. If you fail to do so, the amount you owe may be deemed an early withdrawal from the plan rather than a loan, subjecting you to taxes and penalties.

Home-equity loans and personal loans

Given the negative aspects of borrowing from a 401(k) plan, it is wise to consider other alternatives. One such alternative is to borrow from a lender rather than from your 401(k).

If you have a substantial amount of equity in your home, a home-equity loan would probably be the most cost-effective way to borrow money. Just remember that a loan using your house as collateral puts your property at risk should you have trouble repaying the loan.

If you don't have enough home equity to fall back on, a personal loan is another alternative. However, personal-loan interest rates are significantly higher than home-equity rates. The actual rate you pay and your ability to qualify for a loan in the first place depend a lot on your credit history and financial situation. If your credit is shaky, this is probably not a great option.

Most likely, the interest you would have to pay on a personal loan would exceed the average investment earnings you would miss out on if you take money out of your 401(k) plan balance by borrowing. However, personal-loan rates are generally cheaper than simply adding to a credit card balance, which is often the first thing people do when short of money.

Hardship withdrawal

Depending on the nature of your financial need, you may qualify for a hardship withdrawal which would allow you to take money out of a 401(k) plan without the 10% early withdrawal penalty. Examples of needs that can qualify for a hardship withdrawal include:

  • Total and permanent disability
  • A Qualified Domestic Relations Order
  • Certain unreimbursed medical expenses
  • Deployment of certain military reservists

The specifics of what qualifies as a hardship withdrawal depend on the 401(k) plan document. Be sure to check with your employer before you assume that you qualify for a hardship withdrawal.

403(b) and 457 plan exemption

Finally, government employers often offer a 403(b) or a 457 plan, which are similar to corporate 401(k) plans. Certain public safety employees are allowed to take money out of these retirement plans at age 50 rather than age 59 1/2. If you believe your profession might qualify you for this exemption, you should check with your employer.

IRA vs. 401(k) early withdrawal rules

Individual retirement arrangements (IRAs) have some features in common with 401(k) plans. Both offer the possibility of tax-deferred contributions to retirement savings and tax-deferred investment appreciation.

In return for these tax advantages, both IRAs and 401(k)s have a 10% penalty if you take money out of the plan before reaching retirement age. However, IRAs have exceptions to this penalty that 401(k) plans don't.

For example, IRAs have early withdrawal penalty exceptions that can apply to the purchase of a first home, higher education expenses and health insurance premiums during periods of unemployment.

If your financial need stems from one of those situations and you or your spouse have an IRA balance in addition to a 401(k), you should consider taking money out of the IRA rather than from the 401(k). Check with your IRA plan custodian to confirm whether your situation qualifies for an exemption to the penalty.

Making up for a 401(k) early withdrawal

Whatever method of early 401(k) withdrawal you choose, keep in mind that any such withdrawal means you will face a future financial sacrifice in exchange for using the money to meet your immediate need. This sacrifice might take the form of living on less money in retirement, working longer or making larger contributions in future years.

If you choose to make larger contributions, you may be able to take advantage of catch-up contributions, which raise the annual 401(k) contribution limit for employees aged 50 and over.

The full price you may pay - both now and later - for an early 401(k) distribution is something you should recognize and consider before taking the step of withdrawing money from a 401(k) plan prior to retirement age.

How to preserve your 401(k) account

Before you incur a penalty for an early 401(k) withdrawal, consider these alternatives:

  1. Go into emergency mode as soon as trouble strikes.

    When people get laid off, they tend to preserve their old lifestyles as long as possible. However, sometimes it can take a very long time to land a new job.

    The best approach is to acknowledge the situation and go into emergency mode as soon as possible. Better to take a temporary step back in lifestyle than suffer permanent damage to your 401(k).

  2. Step up your job search and compromise on your job demands.

    If you've lost your job and are holding out for an equivalent position, you may have a long wait. Flexibility works in this kind of situation. Consider a lower paying job - when you add in what you are saving by not paying a 401(k) penalty, it might not represent such a big pay cut after all.

Saving for retirement is a long-term commitment; however, difficult financial choices need to be made sometimes. The bottom line is that 10% is a huge penalty to pay for accessing your money, not to mention the lost tax-free investment growth. It is worth doing everything you can to avoid taking an early withdrawal from your 401(k).

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