You won’t find many financial advisors who vigorously advocate dipping into the money in your 401(k) retirement account while you’re still working. It is for retirement, after all. Still, using some of what could be a sizeable amount of money sitting in the account for current financial needs may sometimes be too great a temptation to resist. Taking that step is not always ill-advised, but you should know all the ramifications before doing so.
The first way to access funds in a 401(k) before retirement is by borrowing from the account. Generally you can borrow up to 50% of the vested amount in the account, up to a maximum of $50,000. As compared with shopping around for a loan, this approach has the relative advantages of involving minimal paperwork, bypassing credit scores, and paying the interest payments on the loan back to your own retirement account.
A downside for borrowing from a 401(k) account is that to the extent that you deplete the balance in the account, you will have less money with which to take advantage of tax-deferred accumulation in the account. As the borrower, you must also be wary of adverse tax consequences.
First, the loan will be repaid by reductions in your future paychecks, and, unlike the usual contributions to a 401(k) account, those repayments will be made with after-tax dollars; this means that such repayment amounts will be taxed twice, once when the money is initially paid to you and again when you take the money out when you retire.
Second, while you would generally have five years to repay the loan, if you leave the company earlier you may have to repay the loan in as few as 60 days. Failure to meet that deadline would result in owing income tax on the unpaid loan amount and, if you are under age 55, also paying a 10% penalty, to boot.
Another alternative for getting early access to a 401(k) account is a hardship withdrawal, but the name means what it says. The IRS says that there must be an immediate and heavy financial need, usually meaning expenses for items such as medical care, education, or housing or funeral expenses.
A hardship withdrawal is not subject to the dollar-limit for loans, but generally you can’t even qualify for a hardship withdrawal unless you can’t meet your financial obligations from other resources. In the same vein, if you are eligible, you may have to borrow as much as possible from the 401(k) account first, before getting a hardship withdrawal.
However, if using up your other resources and taking out a 401(k) loan will increase your need, the employer can’t withhold a hardship withdrawal for your failure to have taken those steps first. Hardship withdrawals are subject to ordinary income tax and, depending on the timing, an additional 10% early withdrawal penalty.
Our lives are full of surprises, some of them financial. Sometimes unforeseen circumstances will arise that make a 401(k) loan or hardship withdrawal a reasonable step toward meeting pressing immediate needs and therefore achieving more financial stability. Still, the conventional wisdom on this topic holds true: These steps should be taken only when all other approaches have been exhausted or found to be unavailable for some reason.