Millions of Americans face financial hardship every year. Far too many immediately turn to their 401(k) plan to fix their problems. No matter how huge today’s problems may seem, drawing from your 401(k) account before retirement will almost always create even larger problems in the years to come.
Let’s start with an example. Paula has been a diligent saver throughout her career. She began saving 7% of her salary at the age of 30 and receives a 3% employer match. At the age of 40, she undergoes a $10,000 knee surgery that her insurance won’t cover, and she looks to her 401(k) plan to pay for it. The long-term impacts of her three options are summarized below.
|Hardship Withdrawal / Loan Impact ||Alternative Source ||Hardship Withdrawal ||5 Year Loan |
|Annual Salary ||$45,000 ||$45,000 ||$45,000 |
|7% Annual Before-Tax Salary Deferral Plus 3% Employer Match ||$4,500 ||$4,500 ||$4,500 |
|Years of Savings ||35 ||35 ||35 |
| Investment Return ||8% ||8% ||8% |
| Money Taken from 401(k) After 10 Years of Saving ||$0 ||$10,000 ||$10,000 |
|Fees, Taxes, Penalties ||$0 ||$5,385 ||$4,009 |
|Future Value of 401(k) at Age 65 ||$652,574 ||$546,953 ||$578,205 |
|Lost Value of 401(k) After 25 Years ||$0 ||$105,621 ||$74,369 |
You are probably wondering why an extra $10,000 in your pocket today has such a massive impact on your account balance.
401(k) Hardship Withdrawal
Let’s start with the hardship withdrawal. You must have an "immediate and heavy" financial need where you lack other available resources. Following are the typical financial needs considered immediate and heavy: Expenses incurred or necessary for medical care for you or your spouse, children, or dependents; The purchase (excluding mortgage payments) of a principal residence; Payment of tuition and related educational fees for the next 12 months of post-secondary education for you or your spouse, children or dependents; The need to prevent the eviction of you from your principal residence (or a foreclosure on the mortgage on your principal residence);
Payments for burial or funeral expenses for your deceased parent, spouse, children or dependents; or Expenses for the repair of damage to your principal residence that would qualify for the casualty deduction on your Federal tax return.
If your situation does fall into one of the approved categories, there are three main reasons a retirement plan account balance will suffer:
- Taxes and penalties,
- Suspension of salary deferrals, and
- Missed growth opportunities.
If you decide to take a hardship withdrawal, you will find yourself paying a mountain of cash to Uncle Sam. The hardship withdrawal will be immediately taxed as ordinary income. On top of that, if you are under 59 ½, you will face a 10% early withdrawal penalty. This means that Paula will end up paying $15,385 in order to get the $10,000 she wants.
Upon taking a hardship withdrawal, you are prohibited from contributing to your 401(k) for the next six months. You will miss out on any employer contributions dependent upon salary deferrals that could have further built up your savings.
This brings us to the final pitfall: missed growth opportunity. That $15,385 that Paula withdraws could have grown to over $110,000 if she left it in her account for 25 years.
An option that often looks more attractive to employees is a 401(k) loan. You don’t need to show any financial hardship, and the repayments you make go right back into your account. However, a loan can be just as hazardous as a hardship withdrawal.
Imagine you make all the loan payments on time. Your nest egg will suffer similar missed investment growth opportunities, and your taxes will go up as you repay the loan. Unlike other contributions to your 401(k) account, you cannot claim a tax deduction when you are repaying a loan to yourself. Even the loan interest that accumulates will be taxable. You also do not get perks like an employer match on loan repayments. These drawbacks end up costing Paula almost $75,000 in our example.
Keep in mind, you may find yourself in even more dire straits if you default on the loan or stop working for your company while you are still paying it back. When this happens, anything amount not repaid becomes a withdrawal and is subject to all the same taxes and penalties laid out above. This huge tax burden blindsides thousands of 401(k) participants. It could put you in a more difficult situation than when you took the loan.
Think twice before you tap your 401(k) in your hour of need; and then think again. The government sets up these roadblocks for a reason. Your 401(k) is meant for your future, and it will serve you best if you treat it that way.
Still, life sometimes throws curveballs at us at the worst of times. When this happens, consider a few alternatives before turning to your 401(k).
- Temporarily step back your lifestyle. Put off buying that new car. Make dinner at home instead of going out to eat.
- Take a bank loan. Interest rates on 401(k) loans are typically comparable to what you could get from a bank. In addition, the interest on bank loans is often tax deductible. Even if you draw completely from what you usually contribute to your 401(k) to pay back the loan, you will end up with around $2,500 more in your retirement account over a 25-year time horizon and avoid the risks mentioned above.
- Set up an emergency fund today. If you have money set aside that you can use when the unexpected happens, you won’t have to face these tough decisions.
As always, do not hesitate to contact your financial advisor or employer's Benefits Department to request educational support to help you identify possible solutions for your today and your tomorrow.
This is intended for informational purposes only and should not be construed as investment, legal, or tax advice. Please consult with your financial professional regarding your specific situation. Sources: taxfoundation.org