You can be tempted to withdraw money from your 401(k) account everytime you are faced with a cash crunch, say a medical emergency or even a long vacation. But keep in mind; you shall be sinned if you did so before you are 59–1/2. You will be robbing yourself off your future securities for your present day problems.
Apart from missing out on the compounded earnings you’d otherwise receive, you’ll also be levied an early withdrawal penalty and to top all that up – you have to pay Uncle Sam an income tax on the amount withdrawn.
But emergencies can crop up any time so, there are ways of withdrawing from your 401(k) before you are 59-1/2.
401K Hardship withdrawals
Here you can make withdrawals depending on certain hardships that qualify; however, you’d most certainly have to shell out a 10% early-withdrawal penalty (if you’re under 59-1/2) along with some ordinary income taxes. You should be able to see what qualifies as hardship if you go through the fine prints in your 401(k) plan prospectus.
Although every plan varies, some of the hardships that qualify may include: Money for certain medical expenses that aren’t reimbursed by your insurer; money for payment of higher education expenses; money for payments necessary to prevent eviction or foreclosure; withdrawals after the onset of sudden disability; money for the purchase of a first home; and money for burial or funeral costs; money for repair of damages to your principal residence.
You can borrow money against your account and repay yourself, along with interest, as is the provision allowed by most major companies on their 401(k) plans. But this has its own set of restrictions, for instance, most companies will only let you withdraw up to 50% of your vested account value as a loan. The repayment for this, with interest, gets deducted directly from your paycheck.
Borrowing from your 401(k) is quite a cost-effective way to obtain a loan as you’re borrowing your own money and paying less interest on it. This also saves you from extensive credit checks.
Now to the disadvantages:
- Even though you will be repaying the money, you lose out on the compounded interest you’d have otherwise earned had the money stayed untouched in your account.
- A lot of stone-hearted companies will not allow you to continue contributing to your 401(k) while your repayment is active as a result of which, you may miss out on more money.
Matters become more dicey if you were to leave the company—irrespective of whether you quit, get fired or are laid off—you become immediately liable to pay off the loan. Therefore, it is advised that you contemplate the consequences in the event you are left without a job and an imminent loan in your hand.
72(t) of the IRS rule allows you to withdraw a fixed amount based on your life expectancy and the best part about this is that it does not attract any penalty. Under this rule, you must withdraw for a period that’s either at least 5 years or until you are 59-1/2, whichever is longer.
For instance, if you are basking on the fringes of your retirement, say 56, you’ll get a specified amount every year for a period of 5 years till you’re 61. But if you are further from those fringes, say 52, you’ll get that amount every year for 7-1/2 until you are 59-1/2.
In this scheme of things you save the 10% early–withdrawal penalty but you still pay taxes on the amount you withdrew and lose out on the compounded earnings. Should you choose 72(t) payments when you’re way younger than 59-1/2, you get a crappy deal.
Let’s say you are 40 when you begin your 72(t) withdrawals, you will only get small amount every year because you’re life expectancy is long (call it screwed-up astrology) and on the hind side, you end up paying income taxes on it for the next 19-1/2 years.
So the bottom line is; if you do not want to lose out on anything, you should not withdraw at all.