Your 401k is likely to be growing throughout your working life, as you and your employer make monthly contributions to your savings. Hopefully it’s going to provide you with a good nest egg when you transition into retirement. But sometimes life just isn’t quite as straightforward as we want it to be, right? Sometimes you might really be in need of some extra cash.
While it is, in theory, possible to dip into your savings pot and withdraw cash from your 401k ahead of time, is it really something you should be doing?
I generally recommend to my clients that they don’t look at their 401k as a savings account, but only as a designated retirement account. I think it helps to keep its purpose in focus. But that said, rules do allow for early withdrawals and even for loans to be taken out from your 401k account. So if you do for any reason need to access your money early, it’s there to be used. My advice is to always consider all the alternatives first. So why’s that, and what are those alternatives?
Save Your 401k for Your Retirement
For many people, their 401k might be their most significant savings pot. While this isn’t what I generally recommend, it’s the reality of a lot of people’s financial situations. It sure can be difficult sometimes to save over and above your 401k deferrals.
Withdrawing cash from your 401k might feel like a necessary move, but try and avoid it. Whatever the financial markets are doing, I always recommend leaving your 401ks untouched, and leaving them to grow. Any earnings made on your 401k savings are tax-deferred, meaning they’re not going to be adding to your annual tax bill now. Earnings on other savings are, so money in a 401k may well be growing faster than money in other accounts.
Because of the nature of compound interest, the more you have in an account, the harder it’s going to be working for you. If you start taking loans or withdrawals from your 401k pot, you’re limiting its ability to earn. So you’re missing out on potential growth, right from the day you make a withdrawal.
You’ll Pay Taxes and Penalties On Early Withdrawals
There are some other basic disadvantages of taking loans or withdrawals from your 401k. If you’re under the age of 59 and a half, if you make a withdrawal from your 401k, you’ll be charged a 10% penalty. Then you’ll also have to pay tax on that withdrawal as if it was income. So if you withdraw $10,000 from your 401k, you’re actually only going to be able to get your hands on about $6,300.
So you have to ask yourself if it’s really worth it.
Should You Take a Loan From Your 401k?
The rules on loans vary between 401k plans. Some allow you to take a loan of up to 50% of the total amount in the account, to a maximum of $50,000. (Remember that the CARES Act, set up in 2020 to help people to deal with the Covid-19 pandemic, has allowed for a temporary extension of that limit to $100,000.)
If you decide to take a loan from your 401k, then you won’t pay any taxes or penalties on this money. But you do have to pay the loan back within five years, and through additional deductions from your paycheck. You have to be sure that’s something you can afford to do. And if you ended up leaving your employer within those five years, you’ll probably have to pay the outstanding balance back very quickly.
You also have to pay yourself back with interest. However, that interest may well not amount to the same amount of interest that the money would have earned had it been left untouched. So even a loan will end up costing you and your retirement savings. If you can’t pay back the loan for any reason, then withdrawal rules apply instead. You’ll have to then pay the taxes on it, plus the withdrawal penalty.
Withdrawing Cash From Your 401k Might Actually Make Sense
Now, without wanting to create too much confusion, there are times when a loan from your 401k could actually make financial sense. You’ll want to talk this through with a financial advisor though, to make sure you’re definitely doing the right thing.
So for example, if you take the loan to do anything to improve your financial position, then it’s probably OK. Just don’t take it to buy something extravagant, or live beyond your means. Remember, modest living increases your wealth.
So for example, if you have some high interest debts that cost you a lot each month, it might make sense to borrow from your 401k to pay off that debt and lower your monthly outgoings. That will lower the amount you’re going to pay for that debt in the long run. Another example is making home improvements that will raise the value of your home before you sell it. Taking a loan from your 401k then could be a pretty smart move.
But please do see removing funds from your 401k as an absolute last resort. Any dipping into retirement savings puts your future at risk, and could easily mean you end up with less when you come to retire. Keep up your regular deferrals whilst you’re paying any 401k loans back, otherwise you’re at risk of doubly damaging your savings pot.
So what are the alternatives?
Alternatives to Withdrawing Cash From Your 401k
Well, with the benefit of hindsight, I’d say make sure you have another savings pot and not just your 401k. Also consider a health savings account, as they can prevent you from having to take money from your retirement savings to fund medical expenses.
Explore all the options with a financial advisor to make sure you’re making the right decisions. It might be wise to use a small personal loan, or an extra line of credit instead of using retirement savings. An advisor could help to see if there are any other options to free up some cash too, such as swapping a high interest credit card to a lower one.
If you’d like to talk these options through with someone, crunch some numbers and work out what would be in your best interest, just drop us a line. If you’re in need of a cash boost, we can look at your finances and see what makes most sense for you and your future finances.