A few months ago, a client mentioned her plan to take a withdrawal from her 401(k) account to pay off her debt in full. I immediately went into ‘protective mode’ and explained the implications of her decision. I hope she listened – but I’m not an advisor, rather an educator. This blog will discuss two things that often become intertwined. I’ll begin with 401(k) withdrawals.
First, you cannot withdraw from a 401(k) if you are a current employee of the company who is sponsoring your retirement plan. You must terminate your relationship with your employer or retire to withdraw funds from your 401(k). There are certain circumstances where the IRS will allow you to withdraw from your 401(k) as a current employee, which is called a hardship withdrawal. The special circumstances include purchasing a primary residence, avoiding eviction or foreclosure, college tuition for yourself or a dependent, and/or medical bills. You must have documentation on hand to complete this withdrawal to show proof of the special circumstance. Please note that regardless of the circumstance you are still required to pay taxes on the withdrawal.
A very, very important detail regarding withdrawals is your age at the time of withdrawal. If you are over the age of 59 ½, you are only subject to income taxes on the amount of the withdrawal. If you are under the age of 59 ½, you are subject to income taxes plus an additional 10% penalty for withdrawing funds out of your 401(k). The IRS has added an exception to this rule. If you are 55 or over and terminate your employment by retiring or for some other reason, you are not required to pay the penalty for early withdrawal. Another exception to this rule is if you completed a hardship withdrawal for the purchase of a new home, you may be exempt from the penalty come tax time. You must speak to a tax professional regarding the housing exemption, as each circumstance is unique.
To avoid any tax penalty or owing any taxes on withdrawals, you have the option to rollover your 401(k) into another tax sheltered account, including a new employer’s 401(k) plan or an IRA. No taxes will be required at the time the rollover is processed. You may convert your 401(k) into a Roth IRA, but tax penalties will apply. Speak with a tax professional to find out more about this option.
Now for 401(k) loans. During my time working at Fidelity Investments, I could not believe how many people took loans from their 401(k). Here is how a 401k loan works: you borrow from yourself a specific amount of money and pay yourself back plus interest via automatic payroll deductions each paycheck. There is no credit check and you can borrow from yourself for any reason. This is the good news. The bad news far outweighs the benefits. When you pay yourself back, you are paying with after-tax money which means you will eventually be paying taxes on your loan twice because your payments are taxed and you will be paying tax again when you withdraw the funds at retirement. In addition, if you end up withdrawing from your 401(k) before the age of 59 ½ and after you have paid your loan with after tax money, you will have paid taxes twice plus an additional 10% penalty. Can you see why this is not the best idea?
To add another log onto that fire, if you terminate your relationship with your employer prior to paying off your loan in full, the unpaid portion of the loan will be considered a withdrawal where the above mentioned tax penalties apply. For example, say you have terminated your employment and decide you need the money to tide you over until you start working again. The current value of your 401(k) is $10,000. You also have an outstanding loan balance of $3,000 you have not fully paid for. You will be responsible for the taxes on a total of $13,000 ($10,000+$3,000). Most companies are required to withhold 20% regardless of your income tax rate or age. Therefore, you will receive $7,400. If you are under the age of 59 ½, you will only receive $6,100 (additional 10% deducted from $13,000).
As if the taxes aren’t enough of a deterrent from taking a loan out from your 401(k), there is more! To satisfy the loan amount, funds are redeemed (sold) and turned into cash. If the funds were sold for less than what you purchased them for, you have already lost money and continue to depreciate the value of your hard earned dollars by not having your money invested, giving opportunity to increase the deficient value. Additionally, while the money is removed from the account, this reduces your growth opportunity. It is plausible you could earn a significant amount more than the interest you pay yourself back with while investing in your future. By removing the funds from your account, you are limiting the savings potential and thereby limiting the lifestyle you would like to lead during your retirement years.
I realize this particular blog was rather long, but it’s essential to your financial security. I hope this information arms each of you to make the best financial decisions for your own future.
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Consumer Education Services, Inc. (CESI) is a non-profit service provider of comprehensive personal financial education and solutions for all life stages and for all of life’s milestones. Our goal is enhanced economic security for everyone we serve.
CESI is NOT A LOAN COMPANY