If money is tight and you’re eyeing your 401(k) plan as a solution, financial advisors caution that you had better fully grasp the ramifications of tapping your retirement dollars early.
“Just because it’s easy to do doesn’t mean it’s the right decision to make,” said certified financial planner David Demming, founder and president of Demming Financial Services.
About 33 percent of 401(k) investors cash out before reaching age 59½, when most withdrawals can be made without incurring a 10 percent early distribution penalty on top of income taxes owed, according to Fidelity Investments.
Moreover, 21 percent of 401(k) investors had outstanding loans against their accounts at the end of 2012, according to data from the Employee Benefit Research Institute. The average unpaid balance on those loans was $7,153.
So clearly, while 401(k) plans were designed to let workers sock away pretax money for their golden years, these accounts also have become a way for many Americans to finance immediate needs. And if you are hell-bent on doing it, advisors recommend at least going into it with eyes wide open.
If you’re financially strapped, a 401(k) loan can be enticing if your company’s plan allows it. For starters, you’re borrowing from yourself and paying yourself back, with interest.
While a 401(k) loan involves no penalty or tax event, here are some things to consider.
First, depending on your plan’s rules, you might be banned from making new contributions to your 401(k) for six months. This means you won’t benefit from pretax contributions that lower your gross income and help to reduce what you owe at tax time.
Also, unlike 401(k) contributions, loan payments are made with after-tax dollars. And the loan payments — which can last up to five years — are yet another expense for your budget to absorb.
“If you take out a 401(k) loan, you’re clearly already short on cash,” said Vickie Adams, a CFP and owner of her own eponymous firm in San Pedro, California.
Worse, if you lose your job, the loan quickly becomes due. If you’re unable to pay the balance, it typically morphs into an early 401(k) distribution and is subject to the 10 percent penalty, along with income taxes.
“You have to be absolutely secure in your job if you take a loan,” Adams said.
Demming at Demming Financial Services agreed. He has a client who lost his job and will owe about $30,000 in taxes for this year on a $100,000 loan he had taken out against his 401(k) plan account.
The client basically needed the cash to support his lifestyle. Although he earned a six-figure salary, he has been paying a mortgage on a $1 million-plus home and shelling out private-school tuition.
“Sometimes even smart people go into denial when they hear the words, ‘You can’t afford it,'” Demming said.
Anecdotally, many early withdrawals from 401(k) plans occur when people switch jobs.
While some 401(k) plans let you keep your money there after you move on, others will kick you out of the plan, especially if you have a low balance. Next thing you know, you receive a check, and it might be too tempting to cash it instead of avoiding a tax hit by rolling it over into an individual retirement account or your new employer’s 401(k) plan.
According to Fidelity, the average cash-out amount for people under age 40 who are changing jobs is $14,300.
Using that number, the early distribution penalty would shave $1,430 right off the top. Income taxes depend on your income, but say it’s a 20 percent tax hit. That mean’s a tax bill of $2,860. So after paying both the penalty and taxes, you’re left with just over $10,000. And some of that might end up going toward paying taxes due if you don’t have extra cash lying around.
“If there’s a penalty, it’s really hard for me to endorse [an early withdrawal],” Adams said. “I’ve never really had a situation where it would be a good idea.”
Avoiding the penalty
Some early withdrawals are not subject to the 10 percent penalty. One is called a qualified domestic relations order and can be used in a divorce.
Basically, if one spouse is entitled to a share of the ex-spouse’s 401(k), a court-ordered QDRO (pronounced “quadro” by those in the know) allows the recipient to take the retirement money as cash. The amount is subject to income taxes, but not the 10 percent penalty.
“If there are no other liquid assets, this might be the only way for someone in a divorce situation to have access to liquid cash for a deposit on a home or other important starting-over necessities,” Adams said.
But a QDRO is not an automatic part of splitting up retirement funds in a divorce. An experienced attorney must draft the order, have it approved by the court, executed by all parties and accepted by the 401(k) plan administrator.
“We try to give our clients some alternatives. No one has ever yelled at us yet about giving them other choices.”
There’s also the so-called Age 55 Rule. Under this, if you leave the workforce in the calendar year you turn 55 or any time after that, you can take penalty-free distributions from your 401(k).
However, this only applies to the 401(k) you held at the company when you turned 55 and stopped working. If you have a 401(k) at a former employer, that account is off-limits until you turn 59½.
Another exception is called a 72(t) distribution. If you retire early, you can withdraw equal periodic payments of a predetermined amount from your 401(k) for at least five years or until you turn 59½.
You also can take so-called hardship distributions for certain expenses, but you typically will not be excused from paying a penalty.
That is partly why advisors view 401(k) funds as a last-resort option for pre-retirement expenses.
“We try to give our clients some alternatives,” Demming said. “No one has ever yelled at us yet about giving them other choices.”