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8 Smart Reasons to Never Raid Your 401(k)

by Laura Adams

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401(k) Tip #1: Withdrawn or Borrowed Funds Can’t Grow

early 401k withdrawalIt 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.


Published or updated January 2, 2013.
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{ 16 comments… read them below or add one }

1 Pat S

Great points. It’s surely a bad idea to tap those funds. Better to pretend they don’t exist.

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2 krantcents

The answer to “How to avoid dipping…….” is simple, take control of your finances. Perhaps I am a control freak, but I don’t like the idea of my finances controlling me! There are huge rewards for controlling your finances, it is called freedom.

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3 Laura Adams

@Pat S Yes, if you have the option to make a withdrawal or a loan from a retirement account, it’s just better to pretend that you don’t!

@krantcents Absolutely! I couldn’t agree more that having a take-charge, proactive mindset about money is key for success.

I’m actually doing a free teleseminar on this important topic called “Money Mindset Solutions: 5 Ways to Transform Your Finances Now.” I’m going to cover specific techniques and tools you can use to identify and break through mental roadblocks that are holding you back from making smart money decisions. I’ll tell you how to set the right financial goals that you can stick to for good, and lots more. Please visit http://MoneyMindsetSolutions.com to learn more and register for the free event (or to share the info with someone who might benefit)!

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4 James

First they came up with Social Security.
Then they started taxing that at 85% of total.
Then they tax you on any money you get from S.S.
So, they come up with IRA’s and 401’s.
You save and then you can pay taxes to the Gov’t for your money that you saved, becasue the S.S. system was another Gov’t blunder idea.
Face the facts America, the Gov’t is broke. It over promised and now will take every nickel it can make a law to get.
The Land of Opportunity!!!

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5 Tim

The only good thing about taking a loan from a 401K that you forgot to mention is that the interest you pay on the loan is technically paid to yourself. You are borrowing money from yourself, not a bank. So it’s better than taking a loan from a home equity line where you are paying interest to someone else.

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6 Ryan

That is true, Tim, but you are also hurting your chances to earn money on your investments and you also run the risk of having the loan come due immediately if you leave your job for any reason. It’s a very risky proposition.

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7 Gwen Arthur

Hi:
I am a federal employee with a 401K plan (thrift savings plan) I did not see you address the ongoing proposition this money hungry government of ours has to “tap” into people’s thrift saving plan (TSP) to use those trillions of dollars to finance the trillions of dollars in debt this adm keeps spending. And we whose accounts get “tapped into” will be issued wonderful U.S. savings bonds, which are really actually worthless. In other words, the govt wants to steal our money and issue us nothing in return. What would you say about someone taking their TSP money out and at least have something just in case this happens? Obama certainly has his eyes on this. I am 55, so if I take my money out, I will have that nice 10% penalty in addition to tax taken out. Have you been asked this question; if so, what would you say about this? thanks

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8 Ryan

Hi Gwen, I’m familiar with the Thrift Savings Plan, and cover it extensively on out sister site, The Military Wallet. The first thing to know is the government does not have access to the funds in anyone’s TSP account. They simply cannot make withdrawals from private retirement accounts (your TSP account belongs to you, not the government). Making withdrawals from private Thrift Savings Plan accounts would require an act of Congress and the government workers unions and military lobbyists all but guarantee that wouldn’t happen.

As for making withdrawals, I wouldn’t recommend it because the penalties and fees would guarantee you would lock in a loss on your investments. There is no reason to take a guaranteed loss based on an unsubstantiated fear that something could occur.

Even if the government made plans to do something like this, there would be plenty of debate and advance warning and you would have the option of leaving government service and transferring the full value of your TSP into a 401k if you were to find other employment, or into an IRA.

Additionally, TSP members can make penalty free withdrawals at age 55 if they retire from government service at age 55 or later (age 50 for law enforcement personnel). (source: TSP withdrawals at age 55 and IRS Form 5329).

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9 JW

Ryan, are you kidding me? The government can do anything it wants to. They have the guns. I fully expect some form of government takeover/seizure of our PRIVATE 401ks. Perhaps “only” a portion of them, but that portion might make the 10% penalty seem small by comparison. As for the assertion that there would be plenty of debate and time to react, how much debate was there over the Patriot Act? I am sure there are proposals to do this, just sitting in a file in DC, waiting for the right crisis to come along so it can be justified. It will happen very quickly. Perhaps it will be buried in the next 3,000 page bill to be passed. The government is broke, and will soon begin to get desperate for new revenue sources. This has happened in other countries (just recently in Ireland), and it can happen here.

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10 Ryan

No, I’m not kidding. Unsubstantiated rumors and conspiracy theories supporting government takeovers of 401k plans and IRAs have been around for years and nothing has come of it. And I don’t expect that to change in the near future. But then again, I am not a financial or political expert, and don’t claim to be. If it makes you feel better to withdraw all your retirement investments and load up on gold, canned goods, and ammunition, then go for it. At least you will feel happier and more secure, and quite possibly you will be able to say, “see, I told you so.”

But I hope it won’t come to that.

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11 JW

Ryan, I hope you are right, and I am crazy. But….rumors in the past didn’t come at a time when we had a $14 Trillion debt. Currently, under QE2, the Fed is buying 70% of all treasuries. They do this by creating money out of thin air. When QE2 ends, who will fund the government? The answer is, no one. There is no replacement source of cash for our mad government. So after a short period, QE3 will begin. It can be no other way, unless they cut spending (right!). Or they find another cow to milk. I don’t think Obama would do it in an election year, he’s not that dumb. Only if a severe crisis presented an opportunity (as his buddy, Rahm Emmanuel said, you can’t let a good crisis go to waste). But look to what happened in Ireland, and make your own prediction.
http://www.businessinsider.com/irish-bombshell-government-raids-private-pensions-to-pay-for-jobs-program-2011-5

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12 Ryan

JW, here is my full length response: Can the US Government Seize Your 401k or IRA?.

13 Ken Faulkenberry @AAAMPblog

Thanks for the important article Laura. I have a realative who has done this twice. Unfortunately (or fortunately depending on how you look at it), this person has to no idea how many hundreds of thousands of dollars they have lost for less than 20,000 in withdrawals (less than $15,000 after taxes and penalties). Its sad, and especially devastating when done in at a young age when the money could have compounded for decades!

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14 john

Pretty stupid advice when you consider many retirement accounts lose money year after year. And our government has seizing them in their sites. How much money does anyone believe they will have once the Federal Government is running them.

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15 ronfie

If your 401(k) withdrawal drives your modified adjusted gross income above $75,000, ($110,000 for jointly filing married folks), you start losing your Child Tax Credit.

There may be other tax consequences.

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16 sommers

Yes, Laura needs to look up Teresa Gillarducci. While this “takeover” plan goes back to Bill Clinton’s time in office (at least) it is still being talked about in congress. My thoughts are: they will make it retroactive from some point in time after the issue has been opened for debate.
If Obama wins another term, or even appears a shoo-in, this seizure of private accounts will almost certainly happen.

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