You may have noticed a theme in these articles which has started to repeat itself: money saved into retirement plans is long term money. For multiple reasons, your 401(k) is a bad place to keep your rainy-day savings. Hopefully, you’ve taken this advice to heart and you’ve built up your emergency fund before you started investing for retirement.
Life is going to come at you. Plain and simple. The best thing you can do when it comes to your money is to have a plan already in place for when this happens. If you don’t have a plan, you’re going to be forced to be reactionary and, with your money or with anything else, you’ll pay a price for getting stuck in this position. With your money, that plan includes having a 3-6-month buffer of cash on hand, good savings habits and little to no consumer debt. If you follow those principles, then you are well armed to defend yourself when life happens.
Ok, but how about that 401(k) money?
To be sure, it can be very tempting during those tough moments to wonder about dipping into 401(k) savings. Whether it’s to pay for college tuition for your children or simply to cover expenses during hard times, you might look at that money and think, “But it’s just sitting there. I can put it back!” or “I’ve got plenty of time to earn it back if I keep investing smart.”
The problem is, there are penalties and restrictions that go along with taking money out of your account. While it is your money, it’s not fully under your control. That money has already gone past security and is boarding the flight to retirement; if you call it back now it’s going to cost you. It’s very important you understand what these restrictions are.
There are two sets of rules that you have to follow when you want money out early: your 401(k) plan will have its own set of rules and the IRS has a set of rules. You have to follow both.
Your 401(k) has its own set of rules:
When your company began your 401(k) plan, they had to choose a set rules for allowing employees to pull their money out of the plan early. It’s important that you check with your employer or refer to your plan documents to see if your company allows:
-
- In Service Distributions
-
- Hardship Distributions
-
- Loans
The distribution rules inside your 401(k) plan will be your first stop. You need to see what’s allowed here before you consider the rules/ramifications set forth by the IRS. For example, the IRS says its permissible for loans to be taken against 401(k) plans, but not all 401(k) plans allow loans. Even if the IRS says its ok, your employer doesn’t have to offer it.
The IRS Rules:
The IRS has laid out what can and can’t happen with early distributions from 401(k) plans, and they’ve also spelled out the consequences of taking those early withdrawals.
Here’s how it goes: there are a general set of rules and then there are some named exceptions to those rules.
In general, if you withdraw money early from a 401(k) plan and you’re under the age of 59 ½, you’re going to pay a 10% early withdrawal penalty in addition to the tax owed on the money (assuming your money was a pre-tax contribution).
So, this is going to apply to you unless you qualify for one of the exceptions:
-
- Auto-enrollment: you were auto-enrolled, and you don’t want to be. If you catch it within 90 days, you can get your money out without penalty.
-
- Death: no penalties if you die. Well, except for the penalty of being dead…
-
- Disability: same as death.
-
- Divorce: a judge can order to you to split the account to your ex-spouse under a “Qualified Domestic Relations Order” (QDRO). No penalties for the person sending or receiving the money.
-
- Medical: if you have medical expenses that exceed 10% of your Adjusted Gross Income (AGI) and you’re not being reimbursed by insurance (or anything else), you wan withdrawal from the 401(k) without penalty.
-
- Separation from Service: if you’re over the age of 55 you can withdrawal money without penalty from a 401(k) assuming you’re no longer working for that employer.
This is not an exhaustive list, simply a list of the most commonly used exceptions. Now, it’s important to understand that even if you do qualify for an exception to the 10% penalty, you still owe tax on whatever you withdrawal (unless it’s a ROTH account).
It’s also important to note that if you take an early withdrawal from a retirement plan, you are increasing the likelihood of an IRS audit.
What about loans?
If your employer allows loans in your plan, this can be a better (still not good) option than an early distribution.
A 401(k) loan can be taken out to cover expenses in the short term; these loans typically need to be paid back over five years unless the money is for a home purchase. Your employer will determine the terms of the loan (length, interest rate) while the IRS set the limits for the maximum amount you can borrow:
A) $10,000 or 50% of your vested balance, or
B) $50,000
You have to use whichever amount is less. For example, if you have $9,000 vested in your account, you could conceivable loan out the whole thing. If you have $40,000 then your maximum loan is $20,000. If you have $500,000, your maximum loan is $50,000. Also – if you’ve already had a loan during the past year – your next loan will be limited.
During the loan, you will pay principal and interest back to yourself at an after-tax rate that is automatically taken out of your paycheck (in addition to any money you might want to put into your account anyway).
We should mention a couple of downsides here: while it does seem nice that you get to “be your own bank” and pay yourself interest, it’s actually nothing more than making an additional contribution to the account (the interest you’re paying) which is not even deductible! So, you took the loan because you were short on funds, meaning it might not have been a good idea to be in the 401(k) in the first place, and now you’re putting more money in but not even getting the tax break!
The bigger drawback, however, is that it’s not really a loan. They’re actually sending you the money from your account, which means that it’s no longer invested and working for retirement. As we’ll discuss in a future article, these early years are crucial to starting the “compound interest curve”. If your money isn’t actually in the account and growing, it’s likely you’re short-changing your future self.
Danger Will Robinson:
We don’t mean to be fear mongers, but we do want you to be aware of all the pitfalls and traps when it comes to withdrawing retirement money early. As we said at the beginning, the best thing you can do is follow a set of financial principles before you invest for your retirement.
If you’re in a situation where you feel you may need make an early withdrawal, we would urge you, in the strongest possible terms, to reach out to your financial planner or one of the Invst advisors first. Your company has hired us to help – we are experts in finding lost money, helping people attack their debt and getting your financial actions aligned with your core financial values.
