If you could have $10,000 today or $80,000 to spend 30 years from now, which would you choose?
This isn't a game; it's a real-life scenario many people face when they weigh whether to take early withdrawals from their 401(k) accounts. If you have $10,000 in a retirement fund, and you allow it to grow for 30 years at an average interest rate of 7% per year, it would be worth about $80,000 when it’s time to retire.
However, if you choose to withdraw that $10,000 today, those earnings would be eliminated. Worse, you could automatically lose $1,000 of that disbursement due to the 10% early withdrawal penalty, and after state and federal taxes are applied, you might have closer to $6,000 to spend.
Inevitably, people will disagree on which option is best. Some may urgently need the cash and not have the luxury of letting it grow. Others look at the simple math and opt for the larger sum of money. Still others lack the temperment for delayed gratification, would love a nice vacation this year and will decide to withdraw the money today.
However, tweaking the question may yield different results:
Which would you rather have?
- $0 today and $80,000 in 30 years
- $10,000 today, but you lose $80,000 in 30 years
For many people, the prospect of losing a significant sum of money feels more threatening than the possibility of gaining a modest amount, and more people are likely to reconsider choosing a short-term gain when faced with the second question. This is the perspective people need to take when considering whether to prematurely take money from their retirement accounts.
"A lot of people see this money as something they can spend, and they really shouldn't," said David Rae, a certified financial planner in Los Angeles. "Not unless they're in dire straits—if your electricity is going to be turned off, if the baby isn't going to have food, if you have a terminal illness. … It should never be for a vacation or to buy a nicer, newer car."
There are a few scenarios where dipping into your retirement funds may make sense, such as during a medical emergency or possibly when buying your first home. However, people need to understand the two options open to them, the tax penalties they'll face and the long-term effects taking the money out early will have on their retirement portfolios.
Here are two ways you can take early disbursements from your retirement funds and the effects they'll have on your retirement prospects.
Hardship withdrawals are 401(k) disbursements you are not required to pay back, but the funds must be used to satisfy a qualifying hardship. Your retirement plan is not required to provide hardship withdrawals, but most do.
Generally, the terms of your 401(k) plan will require you to prove you or a beneficiary is facing an immediate and substantial financial hardship, such as a medical emergency or funeral costs, in order to qualify for a hardship withdrawal.
Employees must also prove they do not have any alternate sources of funds available to them that could be used to satisfy the hardship. For example, if you could take out a 401(k) loan (more on that below), or if you have equity in a house, your plan may stipulate that you'd need to take advantage of those assets to fund your hardship before qualifying for a withdrawal.
Discretionary purchases, such as a mortgage down payment, may not qualify. However, your withdrawal might be approved if the funds will be used to prevent eviction from your primary residence, or if your home has been severely damaged and needs immediate repairs. You'll have to consult your plan administrator to determine the stipulations of your plan.
Typically, the most you can withdraw is the amount you've contributed to the plan, less any previous withdrawals. This means that any earnings you've made on your contributions, or any matching contributions your employer has made on your behalf, are ineligible for hardship withdrawals. Additionally, you can't withdraw more than is absolutely necessary to satisfy your hardship and any taxes or penalties incurred by your hardship distribution.
What penalties will you face for taking a hardship withdrawal?
Unless the 401(k) funds withdrawn were after-tax Roth contributions, that amount will be added to your gross annual income and taxed according to state, local and federal tax regulations. Additionally, you may have to pay an early withdrawal tax penalty of 10% if you’re younger than 59.5 and don’t qualify for specific hardship exceptions established by the IRS. Finally, you could be prohibited from contributing to any employer-sponsored retirement plans for six months, forcing you to forfeit any contribution match your employer offers.
These penalties, combined with the fact that hardship withdrawals are permanently removed from your 401(k) plan, mean you could substantially alter your long-term retirement savings. You should seriously consider your other options before taking a hardship withdrawal.
"One of the only times I would recommend withdrawing from retirement funds is if a person or their child has a major medical issue and they need money to pay off those expenses or need something to live off of," Rae said.
If you must use your retirement funds early, 401(k) loans will do the least damage to your savings. Roughly 29% of Americans who participate in a retirement plan reported they've taken out a loan from the plan, according to a survey by TIAA-CREF.
There are two significant benefits a 401(k) loan has over other withdrawal options:
First, 401(k) loans are not subject to income tax or penalties, as long as you repay them on time. This can preserve much-needed funds if you borrow during a financial emergency.
Second, loans require you to pay back the loan amount with interest, reducing the amount of damage you do to your retirement savings. And unlike a mortgage loan, where interest is paid to the lender, the interest on a 401(k) is paid back into your retirement account, sharply minimizing the hit to your savings.
As described above, a $10,000 withdrawal made 30 years early could cost you around $80,000 in retirement. However, if you took out a loan instead and repaid the $10,000 over five years at a 6% interest rate, you may only be out approximately $2,027 in retirement, assuming it would have earned 7% by standing in your account.
Although considerably less significant, this setback is still undesirable—especially if you're unsure you have enough saved for retirement as is.
"If you're $5,000 to $10,000 short on a mortgage down payment, and you have a decent-sized 401(k), it's not that big of a deal to take a loan for that amount," Rae said. "But you shouldn't take out half of your 401(k). You'll set yourself so far back for retirement."
Another downside you should consider is the tax treatment of your loan's interest payments. Any interest payments you make when repaying your loan are paid in post-tax dollars. However, as soon as those interest payments enter your 401(k) account, they're treated as pre-tax dollars. This means you'll be taxed on those dollars a second time when you withdraw them in retirement.
Generally, 401(k) loans must be repaid within five years, unless you’re performing military service, using the funds to purchase your first principal residence or taking a leave of absence. In these cases, the loan amount and interest must still be repaid, but your plan's administrator might offer an adjusted repayment schedule.
However, if you lose or change jobs during before your loan is paid off, you must repay the remaining loan balance within 60 days. If you can’t, that amount will be added to your gross earnings for that year and can create a hefty tax bill.
How much can I borrow?
Plan administrators decide whether you can take out a 401(k) loan. They also determine the terms of the loan, such as its interest rate and whether it's limited to employee contributions or if it can include employer contributions as well.
While your employer's limitations may be more restrictive, IRS law dictates that the maximum loan amount a person can take from their qualified plan is as follows:
- The greater of $10,000 or half of your vested account balance or
- $50,000, whichever is less
For example, if your vested balance is $24,000, half that amount is $12,000. Since that is greater than $10,000, but less than $50,000, the maximum loan you could borrow is $12,000.
If you've determined that you must take out a loan on your 401(k) balance, consult your employer's HR department to find out what rules your plan administrator enforces. After receiving the disbursement, be diligent to stay on schedule with your loan repayments. And keep in mind that the faster you repay your loan, the more you stand to hold in retirement.