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Avoid taking a 401k withdrawal if you can

Even the best retirement plans can be sidetracked when you borrow from a 401k account.

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Last updated: July 12, 2022 |

Article published: January 13, 2022

One of the realities of life is that you never know when it might throw you a curveball. Take, for example, the Covid crisis, when millions of workers were laid off or had their hours or pay reduced – in many cases permanently.

But a pandemic isn’t the only thing that can cause you to lose your job. And if you do, you’ll still have to pay for life’s necessities – housing, utilities, groceries, medical expenses and more, while still saving for retirement.

401k withdrawal rules

In this scenario, it might be tempting to tap into your workplace retirement plan to cover these needs. However, 401k withdrawal rules say that if you take money out of your account before age 59½ you are subject to a 10% penalty, and you will have to pay income tax on the distribution.

But you can avoid the 401k withdrawal penalty, and the taxes, if you take out a loan against your retirement funds instead. Yet, people often make this decision without understanding the consequences of borrowing from a 401k.

Taking a 401k withdrawal is a life-changing decision because it can seriously harm your ability to achieve financial security in retirement. In fact, you could lose as much as half of your potential retirement savings from a single loan event.

How borrowing from your 401k can be detrimental to retirement savings

Let’s say that Mary, age 45, has $100,000 in her 401k and takes out a $50,000 loan, but never repays it. If she hadn’t borrowed that money from her plan, by age 70, her assets would have grown to $1.2 million (assuming a 6% annual contribution rate and 3% employer match). But if Mary defaulted on the loan, at age 70, she would have only $590,247. That’s 50% less.

Borrowing from your retirement account is never ideal, but life sometimes makes it unavoidable. For example, you might need money for medical care, to avoid eviction, to buy a car or pay for car repairs so you can drive to work.

Those are legitimate and necessary expenses, but unfortunately, people often have frivolous or at least questionable reasons for accessing their retirement savings early.

Among those we surveyed, the top reason for taking out such loans was to pay down credit card debt. Other nonessential reasons included vacations, weddings and simply “fun spending.”

And once their “lifeline” is gone – because retirement funds are depleted or borrowing limits are reached – many people find that their financial stress only worsens.

To make matters worse, all too often, those who take a 401k withdrawal don’t understand these critical points:

  • The term “borrow” is really a misnomer. In reality, the “loan” is a withdrawal of funds from a 401k plan.
  • They will pay fees to obtain the loan.
  • They will pay interest while repaying it.
  • And they can also incur a penalty if they don’t repay the loan on time.

In order to “fund” this load, mutual fund shares in the account are sold. Which means those shares no longer exist, causing the borrower to miss out on any subsequent return if those shares rise in value. Some plans don’t allow individuals to continue contributing to their accounts until the loan is fully repaid. So not only are they prevented from saving for retirement, but they’ll also miss out on employer matching contributions. This just adds to the missed gains opportunities during the repayment period.

Meanwhile, being unable to contribute to an employer-sponsored plan increases one’s take-home pay, raising tax liabilities. Money in a 401k plan is also protected from creditors. But once you remove it through a loan or withdrawal, that protection is lost and creditors can sue, forcing you to repay, negotiate a settlement or seek bankruptcy protection.

Seek financial security

As you can see, taking withdrawals from your retirement account is fraught with many problems. It’s partly why we always recommend that you maintain sufficient cash reserves – so you have the financial flexibility you need to cover unforeseen expenses.

And even in a situation where 401k early withdrawal exceptions apply, and you could withdraw funds from your account without paying a penalty, as we saw in Mary’s example above, the potential negative impact on your ability to save for retirement is too great and should be avoided if at all possible.

So if your financial situation has changed during the pandemic, or just from one of life’s curveballs, talk to an Edelman Financial Engines advisor. They can help you consider all the options to help you avoid borrowing from a 401k or withdrawing funds from any retirement accounts.

 

This is a hypothetical illustration meant to demonstrate the principle of compound interest and is not representative of past or future returns of any specific investment vehicle. They do not include consideration of the investment fees or expenses, time value of money, inflation, fluctuations in principal or taxes.

Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.

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