401k retirement accounts have one true purpose and that is to help you save for your future. This is where some investors have a conflict.
401k retirement accounts were established by the federal government to allow investors to put money away for retirement on a tax deferred basis.
401k’s are not meant to pay for immediate financial needs; that’s what savings accounts are for; which is where the conflict comes in.
When you have an immediate financial need due to the economic melt down, tapping into your 401k looks like a good idea. But any good financial planner will advise against tapping into your 401k retirement account for emergency cash. A good financial planner will tell you to use other sources of funds first.
Even though 401k withdrawals, 401k hardship withdrawals and 401k loans are allowed by law when you need money for a true emergency and have no other option; are they really your best options? Best option or not, sometimes you just have no choice.
When you have a severe financial need with nowhere else to get money, you may realize loans and hardship withdrawals are not your best options, but you have to tap into your 401k anyway.
This 401k conflict is very common due to the hard economic times we are in right now. Some options are less damaging to you financially than others. Let’s review your options and the advantage of each.
Solving Your 401k Conflict:
401k Loan Disadvantages:
- There is no growth on the money while it is out on loan.
- You lose out on compounding while the money is out on loan.
- No growth and no compounding on the loan amount will lower your long-term investment returns.
- If you had to take out a loan, you probably can no longer afford to make your monthly 401k contributions, so you miss out on long-term growth there.
- If you repay your loan, it is not taxed.
- If you do not repay it, you are taxed on the outstanding balance.
- If you do not repay the loan, you are also subject to a 10% penalty on the loan amount.
- If you become unemployed while the loan is outstanding, the loan must be repaid in full within 60 days.
- A loan cannot be rolled over to an IRA.
401k Loan Advantages:
- There are very few advantages.
- It’s easy, very little administration.
- You can borrow up to 50% of your vested account balance.
- The interest rate is usually reasonable.
- The repayments are payroll deducted.
- There are generally no restrictions to take out a 401k loan.
401k Hardship Withdrawal Disadvantages:
- There are restrictions to taking out a 401k hardship withdrawal.
- You have to qualify for a hardship loan.
- The IRS only allows a 401k hardship withdrawal under the following circumstances:
- College tuition.
- Medical expenses that are not reimbursed.
- Purchase of a principal residence (a vacation residence does not qualify)
- Any payments necessary to prevent eviction from your home or to prevent the foreclosure of your principal residence (a vacation residence does not qualify).
- Funeral expenses (as of January, 2006)
- Your withdrawal amount cannot exceed the exact amount of the financial need.
- All 401k hardship withdrawals are subject to taxes.
- If you are not at least 59 1/2 years old at the time of the withdrawal you will also be subject to the 10% withdrawal penalty.
- You cannot change your mind; once a hardship withdrawal has been processed, it cannot be returned to your account.
401k Hardship Withdrawal Advantages:
- There aren’t too many advantages.
- You get your money for a severe financial need.
- You do not have to repay a 401k hardship withdrawal like you do a 401k loan.
- Look for money from other sources.
- Stay out of the financial bind to begin with.
- Don’t spend more than you make.
During tough economic times even though you don’t want to use your 401k account for the wrong reasons, you may have to. Just remember that it can get very expensive if you mishandle your 401k loans or hardship withdrawals. You could end up paying 401k taxes and penalties.
Even though 401k loans and hardship withdrawals are allowed by law, employers are not required to offer them in their 401k plans. If you get serious about taking out a loan or making a withdrawal, ask your 401k plan administrator whether or not your 401k plan does offer loans and or hardship withdrawals.