Episode 190: September 20, 2010
by Laura Adams
Many people are tempted to take money out of their work retirement plan when they hit a financial rough patch. Before you pull the trigger and take an early withdrawal from a 401(k) or a 403(b), you need to fully understand the rules and penalties. In this article I'll cover when you can take a withdrawal and why you should never take money out of a retirement plan if you can help it.
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What Is a 401(k) Retirement Plan?
First, let me back up and briefly explain 401(k) and 403(b) retirement plans. They're offered by employers so workers can easily save money for retirement. One of the best features of these plans is that many employers “match” all or a portion of an employee's contributions by depositing additional funds into their account. Most corporations can set up a 401(k) plan, but a 403(b) is available for certain organizations, such as non-profits, public schools, hospitals, and churches only. (There are also 457 plans for state and local government workers and a Thrift Savings Plan for federal employees—but they operate under slightly different rules.)
What Is a 401(k) Hardship Withdrawal?
Many people mistakenly believe that they can take money out of a 401(k) or a 403(b) at any time and for any reason. If you're counting on using 401(k) funds to pay for your next vacation or to buy a car, I hate to disappoint you, but it isn't allowed. You can only take money out of one of these plans when you reach the age of 59½, qualify for a hardship, leave the job, become disabled, or die.
Workplace retirement plans have very strict rules about when you can take money out and some plans don't allow for any kind of hardship withdrawal. The IRS specifies that taking a hardship distribution can only be allowed in the following situations:
to prevent eviction from, or a foreclosure on, your primary residence;
to purchase a primary residence;
to pay for repairs to your primary residence;
to pay unreimbursed medical bills for you or your family;
to pay funeral expenses;
The amount you can withdraw from your retirement plan for a hardship is limited to your total contributions (which is also known as your “elective deferrals”), and generally can't include any matching funds or earnings on your account. Some plans require that you first exhaust all your other options—such as applying for a commercial loan, liquidating assets, or borrowing from your retirement plan—before you can take a hardship withdrawal.
When you take a hardship distribution, you can't just put the money back in at a future date because it's not a loan. Contributions to workplace plans can only come from payroll deductions. By the way, I'm going to cover the topic of taking loans from a 401(k) or a 403(b) in next week's article.
I recommend that you never take money out of a retirement plan if you can help it. Here are four reasons why tapping your 401(k) or 403(b) is a bad financial move:
There's an automatic 10% penalty if you're younger than age 59½.
You lose out on years or decades of account growth.
You’re usually subject to a six-month waiting period where you can’t make new contributions.
Retirement accounts are protected if you (or your company) declare bankruptcy.
What Is the 401(k) Early Withdrawal Penalty?
When you take money out of a retirement account due to a hardship before the official retirement age of 59½, it’s called an early withdrawal. The government discourages you from doing that by imposing a hefty 10% penalty on amounts that you cash out—except in a few situations, such as when you have a court order to split up the account due to a divorce or you become disabled. In addition to the penalty, you also have to pay income tax on any amount you withdraw that wasn't previously taxed.
Here's an example of how expensive it is to take an early withdrawal: Let's say you've contributed $25,000 to your traditional 401(k) and you want to cash it out to buy a home. If your average tax rate is 28%, the 10% penalty makes the total amount you'll owe the government 38%, or $9,500. That only leaves you with $15,500 ($25,000 - $9,500).
What Is the Opportunity Cost of Taking a 401(k) Early Withdrawal?
If you cash out your retirement account and end up declaring bankruptcy later on, you may have spent your retirement money for nothing.
If you think taking an early withdrawal sounds expensive on the front end—they're outrageously expensive in the long-term. The opportunity cost, which is the benefit you would have received if you hadn't taken an early withdrawal, is massive! That's because you lose out on all the potential investment gains and tax benefits that would occur over the long-term. Remember that once you take a hardship withdrawal, you can't just repay it to your retirement account.
Another rule that comes with taking a hardship withdrawal is that you're usually subject to a six-month waiting period where you can't make any new contributions. So not only do you miss out on adding to your retirement nest egg, but you don't get additional funds that your employer might offer as a matching contribution.
Going back to my previous example, let's say you decided not to cash out your $25,000. If you didn't contribute another dime to the account and had 20 years until retirement, you'd have close to $83,000 in the account, even with a modest 6% annual return on your investment. If you contributed $250 a month for those 20 years and got the same annual return, you'd have over $198,000. And if your employer kicked in an extra $125 a month in matching funds, you'd really be sitting pretty with close to $257,000 at retirement!
So your choice is to take a withdrawal that will net you a mere $15,500 after the penalty and taxes, or to resist the temptation to cash out and to potentially amass hundreds of thousands of dollars for a secure financial future. Try out the 401(k) Savings Calculator at bankrate.com to find out how much you could accumulate for your dream retirement.
How Are Retirement Accounts Protected in Bankruptcy?
One of the benefits of a 401(k) and 403(b) retirement account is that they're protected by federal law if you (or your company) declare bankruptcy. That means dipping into them should be done only after you've consulted with an accountant or even with a bankruptcy attorney. It would be foolish to deplete your retirement funds when your creditors aren't legally allowed to touch them. If you cash out your retirement and then end up declaring bankruptcy later on, you may have spent your retirement money for nothing.
So remember that a hasty withdrawal could be devastating to your future financial security. If your workplace retirement plan offers a loan as an alternative to taking a hardship withdrawal, that may be a better option. Join me again next week for more information about the topic of taking loans from a 401(k) or 403(b).
Here's one more quick and dirty tip that can turbo-charge your retirement nest egg: When you leave a job, never cash out your retirement account. Instead, roll it over into an IRA or into the retirement plan at your new employer. That leaves your money invested and working for you so it'll be there when you need it during your retirement.
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