Whats The Difference Between A Withdrawal And A 401 Loan
With a 401 loan, you must repay the money back into your account over a period of time. With a standard withdrawal, there are no repayment requirements. You will be charged interest on the loan, although you are technically paying the interest back to yourself. The money goes back into your 401 account, and you usually can spread the payments out up to 5 years. If you are using the money for a down payment on a home, you can even spread them over 15 years. A loan is usually a much better option than a withdrawal because at least you will be replacing the money. However, not all plans offer 401 loans, so that might not be an option for you.
What Qualifies As A Hardship Withdrawal For 401k
A hardship distribution is a withdrawal from a participants elective deferral account made because of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need. The money is taxed to the participant and is not paid back to the borrowers account.
Living With A Disability
If you become totally and permanently disabled, getting access to your retirement account early becomes easier. In this case, the government allows you to withdraw funds before age 59½ without penalty. Be prepared to prove that youre truly unable to work. Disability payments from either Social Security or an insurance carrier usually suffice, though a doctor’s confirmation of your disability is frequently required.
Keep in mind that if you are permanently disabled, you may need your 401 even more than most investors. Therefore, tapping your account should be a last resort, even if you lose the ability to work.
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See If You Qualify For An Exception To The 10% Tax Penalty
Generally, the IRS will waive it if any of these situations apply to you:
You choose to receive substantially equal periodic payments. Basically, you agree to take a series of equal payments from your account. They begin after you stop working, continue for life and generally have to stay the same for at least five years or until you hit 59½ . A lot of rules apply to this option, so be sure to check with a qualified financial advisor first.
You leave your job. This works only if it happens in the year you turn 55 or later .
You have to divvy up a 401 in a divorce. If the courts qualified domestic relations order in your divorce requires cashing out a 401 to split with your ex, the withdrawal to do that might be penalty-free.
Other exceptions might get you out of the 10% penalty if you’re cashing out a 401 or making a 401 early withdrawal:
You become or are disabled.
You rolled the account over to another retirement plan .
Payments were made to your beneficiary or estate after you died.
You gave birth to a child or adopted a child during the year .
The money paid an IRS levy.
You were a victim of a disaster for which the IRS granted relief.
You overcontributed or were auto-enrolled in a 401 and want out .
You were a military reservist called to active duty.
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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For Many This Relief Simply Isn’t An Option
Only about half the workforce has a retirement account, says Olivia S. Mitchell, professor of insurance/risk management and business economics and public policy, and executive director of Wharton’s Pension Research Council at the University of Pennsylvania.
And many have far less than $100,000 saved. A recent report found pre-retirees, Americans 56 to 61, had a median balance of $21,000 in their 401 accounts in 2016, which is the most up-to-date data on file. That total reflects almost 30 years of savings. Younger generations do not fare much better. Older millennials have about $1,000 saved in their 401s.
Not only that, but employees with retirement accounts tend to be the higher paid, better educated and longer-term workers. “Therefore allowing people to tap into their retirement accounts won’t help the millions who have no accounts,” Mitchell says. “Those with no accounts are also likely to be the people that will be needing the most help.”
Additionally, Mitchell predicts that the U.S. will see an increase in applications for early Social Security benefits, particularly if the recession is long and hard. “People taking early benefits will end up with a lifetime of lower payouts, and if they already ate into their 401s, they’ll be more likely to face shortfalls in their later years,” she says.
Your Retirement Money Is Safe From Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe. If youre having problems managing your debt, its better to seek alternatives other than an early withdrawal, which will also come with a high penalty.
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When A Problem Occurs
The vast majority of 401 plans operate fairly, efficiently and in a manner that satisfies everyone involved. But problems can arise. The Department of Labor lists signs that might alert you to potential problems with your plan including:
- consistently late or irregular account statements
- late or irregular investment of your contributions
- inaccurate account balance
Who Should Withdraw From Their 401 Early
Just because you qualify for a hardship-related withdrawal doesnt mean you should take one without weighing all your other options.
The experts we spoke with were all in agreement that withdrawing from your 401 shouldnt be your first move. However, they also indicated that if youre truly in need, then you should take advantage of the CARES Acts allowances.
It should be a last resort option. People shouldnt get carried away and start using their 401 assets just because they can, Pfau says.
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Consider Tax Loss Harvesting
Tax-loss harvesting helps investors minimize what they pay in capital gains taxes by offsetting the amount they must claim as income. Capital losses occur any time an asset diminishes in value and is sold for a price lower than the initial purchase price. Selling investments at a loss can lower or even eliminate the amount of taxes paid on gains that year.
Tax-loss harvesting only applies to taxable investment accounts not IRA or 401 accounts, which grow tax-deferred and are not subject to capital gains taxes. Married couples can claim up to $1,500 or up to $3,000 per year in realized losses to offset federal income tax.
Tax-loss harvesting wont help you avoid paying tax on a 401 withdrawal directly, but it can offset your overall tax obligations.
Tips For Retirement Planning
- Meet with your financial advisor to discuss the pros and cons of retiring early. 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.
- If youre considering leaving the workforce ahead of your normal retirement age, learn how it changes your retirement income plan. Use a retirement calculator to estimate how much youll need to retire. A 401 calculator can give you an idea of how much youll be able to grow your savings. This is important to know ahead of your target retirement date.
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Should I Close My 401k And Withdraw My Funds
When American consumers take a whack in the wallet like they did with the coronavirus pandemic in the spring of 2020 asking for relief from their 401k account is a legitimate question.
The legitimate answer is: NO, DONT DO IT!
Not even if the federal government dangles some tantalizing incentives like removing penalties for early withdrawals, which they did during the COVID-19 pandemic in 2020.
The reason temporarily was bold-faced was the option ended December 31, 2020. The 10% penalty for withdrawals before the age 59 ½ is back in play.
Before the CARES Act was passed, taking an early withdrawal was available only to people 59 ½ or older. It was not an advisable choice before COVID-19 and its not an advisable choice after.
If you can avoid it.
A 401k account is a vital part of your financial future and should never be toyed with. However, if something drastic like COVID-19 brings the U.S. economy to its knees and your job/income sinks with it your 401k account might seem like the only ticket to get back on your feet.
Its not for two very good reasons:
- The value of stocks and mutual funds typically plummet during a crisis. Your investment might already have lost a significant amount of its value during a market downturn, meaning you already have significantly less money to borrow from.
- Less money in the account means you definitely will lose out on the gains from compounding interest that make long-term investing so attractive.
Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
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Important Things To Know About Sepp
Like with the Rule of 55, if you dont plan properly and start pulling money out of your retirement plan early you could go broke.
Taking substantially equal periodic payments comes with another big warning:
Once you begin taking distributions, you MUST continue taking distributions until age 59 1/2 OR five years, whichever is longer.
For example, if you start taking payments at age 50, you must take them until age 59 1/2 .
If you start taking payments at age 57, you have to take them until age 62 .
If you start taking distributions and modify or stop taking payments, youll get hit with a retroactive 10% penalty for every year from when you started taking distributions.
Example: Joe is age 50. He decides to start taking SEPP from his 401 of $20,000/year. At age 53 the markets begin a three-year decline At age 56 Joe decides he cant stomach the losses anymore and he needs to stop taking distributions and go back to work or else hes going to run out of money later on. Joe will pay a 10% penalty on $20,000 $2,000 for every one of the six years he took distributions: $2,000 X 6 years = $12,000 tax penalty.
So you see, once you start taking distributions, its a very bad idea to stop. Which is why you need to do your homework and work with a professional whos done 72 work for clients to get the plan right.
Note: The five-year rule is waived upon death or disability.
Helpful In Other Years: Bipartisan Budget Act Changes
There is other good news about accessibility: The Bipartisan Budget Act passed in January 2018 issued new rules that will make it easier to withdraw a larger amount as a hardship withdrawal from a 401 or 403 plan:
An additional change for 2019 was that you are no longer required to take a plan loan before you become eligible for a hardship distribution. However, whether or not you will be allowed to take a hardship distribution is a decision that still remains with your employer. Your employer may also limit the uses of such distributions, such as for medical or funeral costs, as well as require documentation.
Although a hardship withdrawal might be eligible to avoid the 10% penalty, it still incurs income taxes on the sum you withdraw.
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Other Options If You Need Cash
If you are experiencing financial hurdles because of the recent coronavirus outbreak, Ellis recommends exhausting other resources before tapping into your retirement plan balance.
First, consider using any emergency savings you may have. “We recommend our clients keep three to six months’ worth of living expenses in cash for emergencies, which this would definitely fall under,” Ellis says.
If you own a home, you could look into getting a home equity line of credit since housing values have been on the rise and interest rates are low. “You may have the ability to utilize the equity in your home at a low carrying cost,” Ellis says.
If you need cash and don’t have any emergency savings or home equity on hand, consider applying for a personal loan from your bank, which is generally used to consolidate debt or make a big purchase. The average interest rate for a two-year personal loan was about 10.2% in November 2019, according to the latest data from the Federal Reserve.
Keep in mind that the rate depends on both your credit and on the length of the loan, as shorter loans tend to have lower APRs. If you have bad credit, you may be facing an interest rate of up to 36%.
If those options don’t work, you could also tap into a Roth IRA if you have one. With these accounts, you can withdraw any money you’ve invested at any time, without taxes or penalties. But again, remember there’s an opportunity cost to using that money.
The Rule Of 55 For Early Withdrawals From 401s
Here are a few things to keep in mind when considering retiring between age 55 and 59 1/2 and using the Rule of 55 to take early distributions:
If all that looks good to you, thats the simpler and less risky of the two methods to get your money sooner.
The pros of using the Rule of 55
The cons of using the Rule of 55
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