Since the financial crisis of 2008-2009, taking money out of retirement accounts before you’re actually retired [whether as premature distributions or loans on 401(k) accounts] has become less of a taboo. About 18% of 401(k) plan participants had loans outstanding in this year’s first quarter, according to the Investment Company Institute, the mutual-fund trade group. Some 1.7% of participants took a hardship withdrawal last year, a percentage that has held steady for several years.
While I believe that tapping into retirement accounts should be considered a last resort, I do know that for some it is the only alternative. As such, author Georgette Jasen has provided five questions to ask yourself before deciding whether—or how—to start raiding your 401(k).
By Georgette Jasen
1. What’s the tax hit on a 401(k) loan compared with a withdrawal?
On the surface, there’s no contest. Any withdrawal from a 401(k) is subject to income tax, and if you’re younger than 59½ when you do it, you can usually count on paying an additional 10% tax on the amount withdrawn.
By contrast, a loan isn’t taxable and the interest (paid back to your account) is low compared with most other borrowing—usually one percentage point, sometimes two, over the prime rate, which is now 3.25%. Employees have used such loans to help with down payments on their first house.
You often can apply for a loan from your 401(k) online, there are no credit checks, and it doesn’t appear on your credit report. The maximum loan you can take is usually $50,000 or 50% of the vested balance in the account, whichever is smaller. You pay yourself back with deductions from your paycheck, generally over a period of five years.
Thus, loans appear to have all of the advantages over a withdrawal. In fact, many plans require you to take out a loan first, before the plan will permit a hardship withdrawal.
But it isn’t so simple. For one thing, loans aren’t available in every plan. Some companies now permit only one loan from your 401(k) at a time. That is a change from the past, when the availability of loans was considered a way to maximize participation in a 401(k) and many plans allowed as many as five loans. Now many companies automatically enroll employees, and fewer loans means they can avoid some of the administrative costs involved.
And even if a loan is available, the other questions make the decision a bit more complicated.
2. If I choose a withdrawal, can I avoid some of the tax penalties?
If you’re considering a withdrawal, there are ways to avoid the 10% tax, but not for everyone.
For example, there is no tax penalty if you are 55 or older and have left the employer sponsoring the plan, voluntarily or otherwise. (The minimum age is 50 for certain public-safety officers.) Military reservists called up to active duty also are usually exempt from the additional tax.
You won’t be assessed a penalty if you become disabled or if the withdrawal is to pay unreimbursed medical expenses that amount to more than 10% of your adjusted gross income, or 7.5% if you are over 65. Withdrawals to satisfy a divorce settlement under a qualified domestic-relations order also would be exempt from the penalty.
If you are no longer working for the company sponsoring the 401(k) plan, it is also possible to avoid the tax penalty by taking a series of substantially equal periodic payments over five years or until you are 59½, whichever is longer, although the calculations are complicated and you may want to consult with a financial professional.
Exceptions to the 10% tax penalty are included in Section 72(t) of the Internal Revenue Code.
But not all plans permit withdrawals. Some require documentation and may limit the amount withdrawn to only what’s needed. (For a college-tuition withdrawal, for example, you may have to show that your child is enrolled and what the tuition will be.) The first step is to learn the requirements of your plan.
In many cases, you can take out only what you have put into the plan, not earnings on the investments.
Still, all withdrawals are subject to ordinary income tax, and not all hardship withdrawals are exempt from the 10% penalty. Taking money out of a 401(k) to avoid foreclosure isn’t exempt, for example, nor is a withdrawal to pay for repairs to your home.
Funeral expenses don’t qualify for the penalty exemption, nor does college tuition. If you are able to make a withdrawal for those expenses, expect to pay the additional tax.
For a withdrawal to be penalty-free, you generally should report it on Form 5329 with your federal income-tax return. For more about the IRS rules, go to the IRS website and check out IRS Publication 575. Also on the site, search for “early withdrawals 401k” or “hardship distributions 401k.”
3. Am I feeling solid in my job?
Taking a loan from your 401(k) requires you to have faith in your job security. If you leave your job because you are laid off or even if you just move to another company, the loan balance generally must be repaid within 60 days or it is treated as a distribution, meaning that you may owe income tax plus 10% of the amount withdrawn if you’re younger than 59½.
For many with a loan outstanding who then change jobs, dipping into savings is the only way they can repay the loan balance quickly, unless they cash out of the 401(k) upon leaving, in which case they will owe income tax and may get hit with the tax penalty.
“Typically you can’t pay it back. If you had the money you wouldn’t have taken the loan in the first place,” says Judith Ward, a senior financial planner at T. Rowe Price . “You should be aware of what’s going to happen.”
4. Will I mind my account in a slow lane for six months or more?
You are usually restricted from making contributions to the plan for six months after taking a hardship withdrawal, which further cuts into your retirement assets.
Wells Fargo has an online calculator to estimate costs of a withdrawal, although it doesn’t take into account all individual situations.
One downside of a loan is that the money you borrow won’t be earning what it would have in the 401(k), reducing the power of compounding. That is especially costly in years like 2013 with double-digit returns on stocks. And sometimes borrowers cut back on their 401(k) contributions to offset their loan payments, says Wells Fargo’s Mr. Ready. This is a major source of retirement income, he adds. “Take the minimum possible.”
5. Do I have an IRA alternative?
Those with old 401(k)s, typically from former employers, might consider rolling them over into an IRA, which has looser rules for early withdrawals, says Jean Setzfand, vice president for financial security at AARP.
With an IRA, for example, you wouldn’t be subject to the 10% tax penalty if the withdrawal were to pay college tuition for you, your spouse or your or your spouse’s children or grandchildren.
You also can take penalty-free withdrawals up to $10,000, or $20,000 for a couple, to buy, build or rebuild a first home.
But you can’t roll over a 401(k) sponsored by a current employer. And IRAs don’t offer loans.