Should You Tap Your 401(k) When Urgent Financial Needs Arise?

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Shortly after COVID-19 started and many people lost their jobs, the government permitted penalty-free 401(k) withdrawals for people short on cash. There was a limit to the withdrawal of $100,000, which had to be paid back within three years—if it was to remain penalty-free. Many people took advantage of the opportunity, but hindsight asks whether or not this was a good move.

Thinking Ahead

It is easy to think that you can make up for lost time and rebuild your 401(k) if you borrow from it. The primary problem with this is that you have no idea what will happen tomorrow. Considering that most 401(k)s lost about 20-plus percent of their value over the past year, it reveals that some things may be beyond your control.

If you lost a high-paying job, you may not get another one with a similar salary. After all, several candidates would be willing to take your job for considerably less pay—and your previous company would be glad to fill the position on those terms.

You Incur Penalties When Withdrawing Early

Today, if you make 401(k) withdrawals before reaching 59½, you must pay some penalties. During COVID-19, there were no penalties, but now they are back. A 401(k) enables you to save money for your retirement years, and the government created a penalty for early withdrawals.

Double Taxation

Taking money from your retirement account may be tempting, but consider the following first. You will pay more for it than you want, but if you have an emergency and no other choice, it is available. Taking the money out of your 401(k) requires you to pay taxes on the withdrawals and a 10 percent penalty fee.

Content.Schwab says that if your company allows loans from your 401(k), it is better than making a withdrawal. Since it is a loan, there will be interest, which will be about 1 percent or 2 percent higher than the prime rate. Although you are paying the interest to yourself, you must pay it. The worst part is that you are paying with money that has already been taxed—and it will be taxed again when you withdraw it in retirement.

Hardship Withdrawals

The Internal Revenue Service allows people in more extreme circumstances to withdraw money from their 401(k) before they turn 59½. The basic requirement is you must have an immediate financial expense that you cannot currently hope to pay.

There are several situations under which you may qualify for a hardship withdrawal 401(k). Investopedia says they include:

• necessary medical treatments
• money for up to 12 months’ worth of educational tuition
• money to prevent foreclosure or eviction
• burial or funeral expenses
• finances to repair a principal residence after a disaster
• using 401(k) to buy a house

When You Leave a Company

There are several choices if you lost your job and had a 401(k) with that employer. One of them is to leave your money in that employer’s account. 401KHelpCenter says that your employer could write you a check if you have less than $5,000 in the account.

Another option would be to transfer the money to your new employer’s account. When you make a direct transfer and do not cash it out, there is no 401(k) early withdrawal penalty, and all taxes continue to be deferred. However, not all companies accept transfers. If you do cash it out, you will pay a penalty and taxes.

A third option, the 401KHelpCenter suggests, would be to move your money to an individual retirement account (IRA). Again, if you make a direct transfer, you will not pay any penalties or taxes. Once in the IRA, you can withdraw money for medical and educational expenses.

Limits on Borrowing

Loans on 401(k)s are limited to the amount that belongs to you—the vested amount—up to $50,000 if you have more than $100,000 in the account. For accounts that have less than $10,000 in them, you can only borrow up to $10,000. Being fully vested—that is, being able to withdraw matching money added by your employer—usually takes three to seven years and is determined by the employer’s plan.

Prepare for Cash Shortages With an Emergency Fund

Emergencies are going to happen to most people sooner or later. Of course, you never know when an emergency will occur, so you need to have a cash reserve ready to meet the need. It will prevent you from borrowing from the bank, putting new charges on your credit cards, or making 401(k) withdrawals.

If you are self-employed, you need to put more aside. It could enable you to pay your bills, keep your health insurance, and enable your business to continue operating so you do not lose all your income.

Alternatives to Tapping Your 401(K)

In addition to having an emergency fund, you may also have other options to get the necessary cash, thereby making a withdrawal from your retirement savings plan unnecessary. If you have owned a home for a few years, you will have some equity in it. You could tap into it with a home equity loan.

Selling off some of your investments is another option to meet urgent financial needs. If you have stock, mutual funds, cryptocurrency, etc., you could cash them in. Although you would have capital gains tax to pay, it would be less expensive than paying an early withdrawal penalty fee and losing the many years of interest in a 401(k) you will likely need in retirement.

Instead of having to tap your 401(k), you could also get a personal loan. Personal loans usually have lower interest rates than credit cards and could enable you to pay off all your bills, giving you a single monthly payment.

Taking money out of your 401(k) should be used only after trying other possible means of getting cash. The only exception to this might be if you are sure you already have enough money in retirement savings in other accounts that your 401(k) money does not matter—but, in that case, you would not need to make a withdrawal anyway.

The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.