By Lee Sherman
It should be said right up front. Taking money from your 401k is a last resort that should only be used in a true emergency such as unreimbursed medical expenses, college tuition, funeral expenses, or the need to prevent foreclosure. While it may help in the short term, it can have a disastrous effect on your retirement. If you absolutely must do this, it’s important to understand the limitations, penalties, and taxes you may incur. There are two ways to go about this:
If you are currently an employee, you may qualify for a loan. A loan lets you borrow money from your 401k savings and pay it back over time with interest. In this case, the loan payments and the interest go right back into your retirement plan account. The maximum amount that you are allowed to borrow is generally 50% of your savings or $50,000, whichever is less, within a 12-month period. If 50% of your vested account balance is less than $10,000, you can borrow up to $10,000 if your plan allows it. Be aware that most plans require you to pay the loan back plus interest within five years. If you can swing it, a loan is the better option here because it keeps your retirement savings relatively intact and it gives you the opportunity to rebuild it over time.
A withdrawal means the money is permanently removed from your account and you’ll be faced with penalties such as a 10% early withdrawal fee and taxes that must be paid upfront. The exception to this is a hardship withdrawal. The IRS allows hardship withdrawals if : (1) the withdrawal is due to an immediate and heavy financial need; (2) the withdrawal must be necessary to satisfy that need (i.e. you have no other funds or way to meet the need); and (3) the withdrawal must not exceed the amount needed.
With the arrival of Covid-19, the government has introduced the CARES Act to cover a new kind of hardship. The CARES Act provides financial assistance to you, your spouse, or a dependent if you’ve either been diagnosed with Covid-19 or have experienced financial hardship as a result of it. If you qualify for assistance, are under the age of 59½ and are withdrawing up to $100,00 from your employer’s retirement plan (401k, 403b or 457) the 10% early withdrawal penalty is waived. Not only that but you might be able to spread out the federal income taxes over a 3-year period or pay the withdrawal back to avoid taxes altogether.
Financial advisors generally recommend that you take the long-term view when it comes to investing for retirement. But life is uncertain and it’s good to know that your 401k is there when you need it. Before you tap into it though, just make sure you’ve exhausted all of your other options.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.