What Not To Do
In the worst of scenarios, you’ll borrow from your retirement plan, fail to repay it and end up with your finances in even worse shape.
Don’t borrow if you’re planning on leaving. Whether you quit your job or you’re fired, you may need to repay the whole balance of your loan within 60 days or else the amount borrowed is considered a taxable distribution.
Don’t ignore your debt-to-income ratio. Treat your plan loan the way you would any other extension of credit. The classic rule of thumb is that no more than 36 percent of your gross monthly income should go toward servicing debt.
This is known as the debt-to-income ratio.
Don’t blow off your plan’s rules for loans. A 2016 study from Aon Hewitt revealed that six in 10 employers have said they’d take steps to curtail the leakage of assets from retirement plans. Those actions include limiting the number of loans available or the amount of money that’s eligible for borrowing.
Plans can also establish their own repayment and schedules, which you’ll need to follow.
“When you take a 401 loan, it comes out of payroll and reduces your take home pay,” said Cox. “Either you follow the payment schedule or you fully remit the balance due.”
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Get Financial Guidance From Your 401 Plan Provider
Whether its best to take a lump sum or one of the other options depends on your personal goals and circumstances. Sometimes its best to talk with an expert one-on-one to determine the right course of action. Small business 401 plan provider Ubiquity offers retirement planning and financial wellness resources for both employers and employees to help our clients feel more secure in their futures.
Taking 401k Distributions In Retirement
Once you are older than 59-1/2 and are ready to take withdrawals, you typically can take a lump-sum distribution or periodic distributions. A lump-sum distribution may give you a big chunk of cash right away, but youll pay income taxes on the entire amount right away. That can take a big bite out of your nest-egg all at once. If you wish to keep your money in your 401K plan , you can typically select an amount to receive monthly or quarterly. Youre allowed to change that amount once a year, although some plans allow you to make changes more frequently. The key, of course, is to manage your distributions so you dont outlive your money.
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Withdrawing When You Retire
After you reach the age of 59 1/2, you may begin taking withdrawals from your 401. If you leave your job in the calendar year when you turn 55 or later, you can also begin taking penalty-free withdrawals from the 401 you had with that current company. If you are a public safety worker, this rule takes effect at the age of 50.
Once you reach 72, you are actually obligated to begin making required minimum distributions or RMDs.
Debt Relief Without Closing My 401k
Before borrowing money from your retirement account, consider other options like nonprofit credit counseling or a home equity loan. You may be able to access a nonprofit debt management plan where your payments are consolidated, without having to take out a new loan. A credit counselor can review your income and expenses and see if you qualify for debt consolidation without taking out a new loan.
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Those Who Truly Need It
It really comes down to need. If you need to withdraw your money, then withdraw your money. Thats really the essence of the CARES Act. It simply makes a need-based withdrawal less harmful. If you dont need to, then dont, says Brandon Renfro, a financial advisor and assistant professor of finance at East Texas Baptist University.
Its important to consider what things will be like after you take a withdrawal and once things are back to a new normal. Under the CARES Act, you have to repay your withdrawal within three years. If you just need a withdrawal to get you through the next few months before you start earning regular paychecks again, it could be a good option.
Withdrawals After Age 59 1/2
Age 59 1/2 is the magic number when it comes to avoiding the penalties associated with early 401 withdrawals. You can take penalty-free withdrawals from 401 assets that have been rolled over into a traditional IRA when you’ve reached this age. You can also take a penalty-free withdrawal if your funds are still in the 401 plan, and you’ve retired.
You can take a withdrawal penalty-free if you’re still working after you reach age 59 1/2, but the rules change a bit. Check with the plan administrator about its specific rules if you’re still working at the company with which you have your 401 assets.
Your plan might offer an “in-service” withdrawal that allows you to access your 401 assets penalty-free, but not all plans offer this option. And remember, the withdrawal will still be subject to income taxes, even if it’s not penalized.
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What Is The Penalty For An Early 401 Withdrawal
Taking money out of your 401 retirement plan early might sound like a good idea compared to borrowing money or putting a large expense on a credit card. But if you cash out your 401 or access your funds before you reach the age of 59 1/2, you will likely face a 10% early withdrawal penalty on the sum you took out. What that means is if you take out $5,000 at age 48, youll lose $500 as a penalty, and youll pay personal income tax on the whole $5,000.
The Costs Of Early 401k Withdrawals
Early withdrawals from an IRA or 401k account can be an expensive proposition because of the hefty penalties they carry under many circumstances.
The IRS allows penalty-free withdrawals from retirement accounts after age 59 ½ and requires withdrawals after age 72 . There are some exceptions to these rules for 401ks and other qualified plans.
Try to think of your retirement savings accounts like a pension. People working towards a pension tend to forget about it until they retire. There is no way they can access it before retirement. While that money is locked up until later in life, it becomes a hugely powerful resource in retirement. The 401k can be a boon to your retirement plan. It gives you flexibility to change jobs without losing your savings. But that all starts to fall apart if you use it like a bank account in the years preceding retirement. Your best bet is usually to consciously avoid tapping any retirement money until youve at least reached the age of 59 ½.
If youre not sure you should take a withdrawal, you can use this calculator to determine how much other people your age have saved.
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Impact Of A 401 Loan Vs Hardship Withdrawal
A 401participant with a $38,000 account balance who borrows $15,000 will have $23,000 left in their account. If that same participant takes a hardship withdrawal for $15,000 instead, they would have to take out $23,810 to cover taxes and penalties, leaving only $14,190 in their account, according to a scenario developed by 401 plan sponsor Fidelity. Also, due to the time value of money and the loss of compounding opportunities, taking out $23,810 now could result in tens of thousands less at retirement, maybe even hundreds of thousands, depending on how long you could let the money compound.
Make Sure Your Investments Are Well Diversified
The first thing you should do if your 401 or IRA is losing money is to check that you are well diversified. You want your money spread among many stocks, bonds, and other investment products. If you have all your savings tied up in a single stock and it plummets, that’s a more serious issue than when you’re invested in 100 things and one of them dips in value.
Few 401s allow you to purchase individual stocks anyway. You’ll be choosing mutual funds and exchange-traded funds . These are groups of investment products you purchase as a package, which is a convenient and affordable way to diversify your portfolio.
You want a mix of stocks and bonds, although your preferred ratio will depend on your goals and risk tolerance. You also need to think about the assets and sectors you invest in. You don’t want to invest too heavily in one industry, like technology. If it has a financial crisis, your portfolio could still lose value even if you’re invested in many different assets within that industry.
While some 401s may offer sector-specific funds, you’re more likely to have a choice between U.S. and international stocks or large-cap and mid- or small-cap funds.
If you suspect a lack of diversification is partly to blame for your 401 or IRA taking a hit, ask a financial advisor for tailored recommendations.
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Convert To A Roth Ira
Money in a 401 plan isnt taxed when you contribute to it, but the money is taxed when you start taking out funds. When you have a Roth IRA, you pay taxes on the money you contribute, but you withdraw tax-free in retirement as long as you meet the qualifications.
Whereas a 401 is set up through an employer, youll have to open your own Roth IRA account through a bank or investment firm.
When You Leave A Job
When you leave a job, you generally have the option to:
- Leave your 401 with your current employer
- Roll over the funds to an IRA
- Roll over the funds to your new employer’s 401.
If you choose any of those options, you will not owe taxes or a 10% penalty. You can also take this money as a distribution, but this will trigger early withdrawal penalties if you are under 59 1/2 .
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Rollover Money: An Easy Option
If youre still working and you cant get money out of your 401 with any of the techniques above, there might be another approach. If you ever made rollover contributions to your 401 into your existing 401, for example), you might be able to take those funds back out. You wont have access to your entire 401 account balance, but you might get a nice chunk of change outat any time, for any reason. Employers are often unaware of this option, so you may need to ask your employer to do some research with your Plan Administrator.
Again, you may have to pay income taxes and tax penalties, and youre raiding your retirement savings, so only use this option when you have no other choice.
Substantially Equal Periodic Payments
Substantially equal periodic payments are another option for withdrawing funds without paying the early distribution penalty if the funds are in an Individual Retirement Account rather than a company-sponsored 401 account.
SEPP withdrawals are not permitted under a qualified retirement plan if you are still working for your employer. However, if the funds are coming from an IRA, you may start SEPP withdrawals at any time.
There is an exception to this rule for taxpayers who die or become permanently disabled.
SEPP must be calculated using one of three methods approved by the Internal Revenue Service : fixed amortization, fixed annuitization, or required minimum distribution . Each method will calculate different withdrawal amounts, so choose the one that is best for your financial needs.
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Broad Range Of Hardships
You may not realize that the purpose of your withdrawal might be allowable as a financial hardship. For example, you can use hardship money to buy or repair your home or pay the doctor. The rules set out in the Code of Federal Regulations, Title 26, Section 1.401-1, list six circumstances in which the financial need for a hardship distribution is immediate and heavy. They are: encountering deductible medical costs purchasing your principal home, excluding mortgage payments paying up to one years qualified education expenses for you or a family member coughing up the rent or mortgage on your main home in order to prevent eviction or foreclosure shelling out money for burial or funeral expenses for a parent, spouse, child or certain other dependents and repairing deductible damage to your main home. The regulations give the Internal Revenue Commissioner some wiggle room to permit hardship distributions for other extraordinary circumstances. You cant get a hardship distribution once your job has terminated.
You May Need To Take Money Out Of A 401 Here’s What You Need To Know
401s are incentivized plans to help Americans save for retirement. The government provides tax breaks to encourage you to contribute, but it also enforces certain rules to discourage you from taking distributions before retirement. In some cases, breaking those rules and taking distributions early can cost you a 10% penalty in addition to the ordinary income taxes you’ll owe on withdrawn funds.
Let’s look at all the approved ways you can take money out of a 401 and look into the penalties you’ll incur if your early distributions don’t fall within one of those exceptions.
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How Are 401 Withdrawals Taxed
If a rollover-eligible withdrawal is made to you in cash, the taxable amount will be reduced by 20% Federal income tax withholding. Non-rollover eligible withdrawals are subject to 10% withholding unless you elect a lower amount. State tax withholding may also apply depending upon your state of residence.
However, your ultimate tax liability on a 401 withdrawal will be based on your Federal income and state tax rates. That means you will receive a tax refund if your actual tax rate is lower than the withholding rate or owe more taxes if its higher.
If a 401 withdrawal is made to you before you reach age 59½, the taxable amount will be subject to a 10% premature withdrawal penalty unless an exception applies. This penalty is meant to discourage you from withdrawing your 401 savings before you need it for retirement. You can avoid the 10% penalty under the following circumstances:
- You terminate service with your employer during or after the calendar year in which you reach age 55
- You are the beneficiary of the death distribution
- You have a qualifying disability
- You are the beneficiary of a Qualified Domestic Relations Order
- Your distribution is due to a plan testing failure
A full list of the exceptions to the 10% premature distribution penalty can be found on the IRS website.
How To Withdraw Money From Your 401
The 401 has become a staple of retirement planning in the U.S. Millions of Americans contribute to their 401 plans with the goal of having enough money to retire comfortably when the time comes. Whether youve reached retirement age or need to tap your 401 early to pay for an unexpected expense, there are various ways to withdraw money from your employer-sponsored retirement account. A financial advisor can steer you through these decisions and help you manage your retirement savings.
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Tips For Getting Retirement Ready
- Retirement planning is complex and can be stressful. If youre not sure what your vision looks like, consider speaking with a financial advisor. Finding a qualified financial advisor doesnt have to be hard. SmartAssets free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If youre ready to find an advisor who can help you achieve your financial goals, get started now.
- Social Security is another source of income you can expect during your senior years. While you shouldnt depend on it, it can help cover smaller expenses during retirement. Find out the amount youll receive with our free Social Security calculator.
Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
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