When people meet me and learn that I’m a financial author and coach, they inevitably have a money question or two that they want to run by me. Lately, an increasing number of people that I’ve met in person or on social media sites like Facebook are fessing up to the fact that they raided their retirement account at work for one reason or another.
They rationalized cracking open their nest egg and now they’re wondering how to play catch up. Unfortunately there’s no good solution for this problem because once retirement funds are tapped, not only are they gone, but you also have to shell out more money for income taxes and penalties if you took a withdrawal.
Even taking a loan from your 401(k) or 403(b), which can seem harmless on the surface, can put you in jeopardy of having to pay taxes and penalties if you leave your job or get fired. In this article I’m going to spell out the top reasons to steer clear of the temptation to dip into your workplace retirement account.
401(k) Tip #1: Withdrawn or Borrowed Funds Can’t Grow
It might seem obvious that taking money out of a retirement account for either a hardship withdrawal or a loan means that you’re killing its potential for tax-deferred investment growth. If your account was anemic to begin with, now you’re really unprepared for the future. You can use a variety of online 401(k) loan calculators to see how much your retirement account would suffer if you borrow from it.
I would never recommend touching retirement funds except in very special circumstances, such as going back to school or financing a business. If the money could bring you a much higher return in the form of a better-paying job or business it could make sense to tap it. But even then it’s certainly a gamble that might not pay off.
401(k) Tip #2: You Owe Tax Plus 10% on Withdrawals
First of all, your employer’s retirement plan must allow hardship withdrawals for it to be an option. Some plans even require that you exhaust all other funding sources, such as a commercial loan or line of credit.
If you do qualify for a hardship withdrawal, and you’re younger than age 59½, the amount you withdraw is still subject to taxes plus a hefty 10% early withdrawal penalty—ouch!
401(k) Tip #3: Withdrawals Can Not Be Repaid
Once you take a hardship withdrawal, you can’t just save up money and deposit it back into your 401(k) or 403(b). Contributions to workplace plans can only come from payroll deductions.
401(k) Tip #4: Taking a Withdrawal Freezes Your Ability to Contribute
Taking a hardship withdrawal gives you an additional financial sucker punch besides the 10% penalty: You’re typically subject to a six-month waiting period where you can’t make any new contributions.
It follows that if you’re desperate for a withdrawal that you probably wouldn’t have the money to make contributions anyway. But that six-month delay just makes things worse because you have a long wait before it’s even possible to get your retirement savings back on track.
401(k) Tip #5: Conventional Loans Might Be Less Expensive
Getting a loan from your retirement plan is penalty-free, but it’s not interest-free. You have to pay your account back at an interest rate specified in your employer’s plan over a five-year period. The interest rate you have to pay could be higher than what you could get on a conventional loan or line of credit, or from a peer to peer loan. If your 401(k) interest rate is lower than other options, it still may not be low enough to make it worthwhile after you factor in the potential gains you’d miss from taking money out.
401(k) Tip #6: Retirement Loan Interest is Not Deductible
The interest that you have to pay yourself back on a 401(k) or 403(b) loan is taxable—even if you use it to buy or remodel a home. On the other hand, the interest you pay for a mortgage or home equity loan can be tax-deductible, which could end up costing you much less on an after-tax basis than a retirement plan loan.
401(k) Tip #7: Loans are Due in Full When You Leave Your Job
Loans from a 401(k) or 403(b) must typically be repaid within five years. But if you quit your job or get canned, the entire balance is due within 60 to 90 days. If you can’t repay the full amount, and you’re younger than age 59½, it’s considered an early withdrawal. That means it’s subject to income tax and that hefty 10% penalty that I mentioned earlier. So never consider borrowing from your workplace account if you’re unhappy with your employer or suspect that they’re unhappy with you.
401(k) Tip #8: 401(k) Funds Have Bankruptcy Protection
This last tip is a really important reason not to touch your retirement account at work. Federal law gives 401(k)s and other “ERISA-qualified plans” exclusion from bankruptcy. That means if your finances really go down the tubes you don’t run the risk of having your 401(k) taken by a bankruptcy court to pay creditors.
How to Avoid Dipping Into a Retirement Account
The best way to make sure that you build wealth for the future is to treat your retirement account like the Roach Motel: Your money checks in but it doesn’t check out! At least not until you’re age 59½ so you don’t get hit with early withdrawal penalties.
Most people are tired of hearing it, but building up an adequate emergency fund is the best way to stay out of a financial jam that would have you salivating over your retirement funds. After all, retirement accounts are meant for retirement and the IRS will give you a serious slap on the wrist when you break their rules. But if you’re in genuine financial straits, cracking open your retirement account can be should be your absolute last resort.