Cracking the Nest Egg Before it Hatches
Friday, April 9th, 2021

If you have a 401(k) plan at work and need some cash, you might be tempted to borrow or withdraw money from it. But keep in mind: the purpose of a 401(k) is to save for retirement.

Use the funds now, and you’ll risk running out of money during your golden years. You may also face stiff tax consequences and penalties for withdrawing money before age 59½. Still, if you’re facing a financial emergency–for instance, your child’s college tuition is almost due, and your 401(k) is the only source of available funds–borrowing money from your 401(k) may be your only option.

Plan loans

To find out if you’re allowed to borrow from your 401(k) plan and under what circumstances, check with your plan’s administrator or read your summary plan description. Some employers allow 401(k) loans only in financial hardship cases, but you may be able to borrow money to buy a car, improve your home, or for other purposes.

Generally, obtaining a 401(k) loan is easy; there’s little paperwork, and there’s no credit check. The fees are limited, too. You may be charged a small processing fee, but that’s generally it.

How much can you borrow?

No matter how much you have in your 401(k) plan, you probably won’t be able to borrow the entire sum. Typically, you can’t borrow more than $50,000 or one-half of your vested plan benefits, whichever is less. (An exception applies if your account value is less than $20,000; in this case, you may be able to borrow up to $10,000, even if this is your entire balance.)

What are the requirements for repaying the loan?

Usually, you have to repay money you’ve borrowed from your 401(k) within five years by making regular payments of combined principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have an extended period to repay the loan.

Make sure you follow your loan’s repayment requirements. If you don’t repay the loan as required, your borrowed money will be considered a taxable distribution. Furthermore, suppose you’re under age 59½. In that case, you’ll owe a 10 percent federal penalty tax, as well as regular income tax on the outstanding loan balance (other than the portion that represents any after-tax or Roth contributions you’ve made to the plan).

What are the advantages of borrowing money from your 401(k)?

· You won’t pay taxes and penalties on the amount you borrow as long as you repay the loan on time.

· Interest rates on 401(k) plan loans must be consistent with the rates charged by banks and other commercial institutions for similar loans.

· In most cases, the interest you pay on borrowed funds is credited to your own plan account; you pay interest to yourself, not to a bank or other lender.

What are the disadvantages of borrowing money from your 401(k)?

· If you don’t repay your plan loan when required, it will generally be treated as a taxable distribution.

· If you leave your employer’s service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you’ll usually be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you’ll owe a 10 percent penalty tax in addition to regular income taxes if you’re under age 59½.

· Loan interest is generally not tax-deductible (unless your principal residence secures the loan).

· In most cases, the amount you borrow is removed from your 401(k) plan account, and your loan payments are credited back to your account. You’ll lose out on any tax-deferred (or, in the case of Roth accounts, potentially tax-free) investment earnings that may have accrued on the borrowed funds had they remained in your 401(k) plan account.

· Loan payments are made with after-tax dollars.

Hardship withdrawals

Your 401(k) plan may have a provision that allows you to withdraw money from the plan while you’re still employed. However, you have to demonstrate “heavy and immediate” financial need and possess no other resources you can use to meet that need (e.g., you can’t borrow from a commercial lender or from a retirement account, and you have no other available savings). It’s up to your employer to determine which financial needs qualify.

Many employers allow hardship withdrawals only to cover the following costs:

· Medical expenses of you, your spouse, children, other dependents, or plan beneficiary

· The burial or funeral expenses of your parent, spouse, children, other dependents, or plan beneficiary

· A maximum of 12 months’ worth of tuition and related educational expenses for post-secondary education for you, your spouse, children, other dependents, or plan beneficiary

· Costs related to the purchase of your principal residence

· Payments to prevent eviction from or foreclosure on your principal residence

· Expenses for the repair of damage to your principal residence after certain casualty losses

Note: You may also be allowed to withdraw funds to pay income tax or penalties on the hardship withdrawal itself if these are due.

Your employer will generally require that you submit your request for a hardship withdrawal in writing.

How much can you withdraw?

Generally, you can’t withdraw more than the total amount you’ve contributed to the plan, minus the amount of any previous hardship withdrawals you’ve made. In some cases, though, you may be able to withdraw the earnings on contributions you’ve made. Check with your plan administrator for more information on the rules that apply to withdrawals from your 401(k) plan.

What are the advantages of withdrawing money from your 401(k) in cases of hardship?

The option to take a hardship withdrawal can come in very handy if you really need money, have no other assets to draw on, and your plan does not allow loans (or if you can’t afford to make loan payments).

What are the disadvantages of withdrawing money from your 401(k) in cases of hardship?

· Taking a hardship withdrawal will reduce your retirement nest egg’s size, and the funds you withdraw will no longer grow tax-deferred.

· Hardship withdrawals are generally subject to federal (and possibly state) income tax. A 10 percent federal penalty tax may also apply if you’re under age 59½. (If you make a hardship withdrawal of your Roth 401(k) contributions, only the portion of the withdrawal representing earnings will be subject to tax and penalties.)

· You may not be able to contribute to your 401(k) plan for six months following a hardship distribution.

What else do I need to know?

Suppose your employer contributes to your 401(k) plan (for example, matching contributions). In that case, you may be able to withdraw those dollars once you become vested (that is, once you own your employer’s contributions). Check with your plan administrator for your plan’s withdrawal rules.

If you are a reservist called to active duty after September 11, 2001, special rules may apply to you.

The bottom line

Many people view cracking into their retirement fund early as a last resort, but it’s tempting all the same. That impulse only grows the more desperate you become, or the more costs get thrown your way. Before you tap into the fund that’s meant to support your golden years, consider speaking to a financial advisor. They’re knowledgeable professionals who can take stock of your situation and help you create a financial plan that accommodates your needs.

Their priority is your goals and financial security. So, you can rest assured that when you work with a financial advisor, you have someone on your side who wants to help you avoid “last resorts” just as much as you do.