When your budget won't let you give gifts to everyone in the world—which is always, by the way—who should you give...
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In tough economic times, families often turn to their 401(k) accounts as a last-ditch financial resource. But that can do much more harm than good for many reasons.
The Hardship Withdrawal
A hardship withdrawal is when you take money out of your 401(k) before you reach age 59 1/2 to meet an immediate financial need. The IRS has tough restrictions on hardship withdrawals, from who can qualify to what the funds can be spent on. So, the fact that these withdrawals are on the rise is evidence of the struggle many families face as they decide between paying the bills and planning a secure retirement.
The current number-one reason for hardship withdrawals is foreclosure prevention, and Dave agrees with this use of 401(k) funds—as long as every other non-debt option has been exhausted, including extra jobs and short sales.
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The second most common reason for a hardship withdrawal is to pay for college tuition. Considering all the different ways you and your child can pay for college without raiding your retirement or going into debt, this is way out of whack. Your kids' college degrees won't feed you at retirement, so keeping your retirement savings intact must be a priority!
Here's what happens when you make a hardship withdrawal from your 401(k):
You get hit with taxes and penalties: Hardship withdrawals are subject to income taxes. Depending on your tax bracket, that means you could give up 30% or more of your withdrawal to the IRS. In addition to that, if you're under age 59 1/2, you'll pay a 10% early withdrawal penalty.
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Contributions cease: You won't be allowed to make contributions to your 401(k) for six months after you take your hardship withdrawal. So you'll miss any investment gains you would have had by contributing during that period. Worse, you'll miss out on your employer match, which is a guaranteed return on your investment!
The 401(k) Loan
To qualify for a 401(k) hardship withdrawal, the IRS requires you to have already gotten—and spent—a 401(k) loan, so, not surprisingly, 401(k) loans are also on the rise. In a 401(k) loan, you borrow money from your own 401(k) account, then pay it back with interest. Most plans allow you to borrow up to 50% of your account's value, up to $50,000. It's easier to qualify for a 401(k) loan, and there are no IRS restrictions on how you spend the money.
A 401(k) loan is another bad choice, however.
- While you can continue to contribute to your 401(k) while you pay back your loan, most people don't because they don't have the money to make the loan payments and contributions.
- If you're laid off or quit your job, the entire balance is due, usually in 60 days. You don't need big debt to show up as soon as you've lost your job.
- If you can't pay the balance, the IRS considers the loan a distribution. Now you're facing income taxes and the 10% early withdrawal penalty.
If you've dinged your 401(k), contact one of Dave's investing Endorsed Local Providers (ELPs). Your ELP will help you get your retirement savings back on track. Contact your ELP today!