In the United States, there are more than a dozen types of tax-advantaged retirement savings accounts. Each has its own set of (often complex) rules about contributions, withdrawals, loans, and penalties on early distributions. Being a smart money manager means keeping your hands off your 401k until you actually retire. However, sometimes life delivers financial catastrophes, from unemployment to emergency car repairs to housing bubbles.
Because of financial disasters, many Americans have been forced to make early withdrawals from retirement accounts, but the cost is huge. In 2010 alone, Americans paid nearly $6 billion in penalties on distributions from retirement accounts, and that's on top of the regular income taxes owed on those distributions.
The Risks of Tapping Your 401K
Money managers note major risks involved in taking money out of your 401k. First, the money withdrawn is subject to income taxes, and depending on your tax bracket, this can be a significant amount. For example, if you're in the 25% tax bracket and withdraw $10,000, your tax liability is $2,500. Therefore, to net $10,000, you would have to withdraw $13,333 to have enough for taxes. And this is before any penalties are assessed on the early withdrawal. Second, you put yourself behind in your retirement savings. Retirement may seem far off, but an early withdrawal can have effects for decades.
Penalties for Tapping Your 401K
The IRS has a few, clearly delineated situations in which you can take an early distribution from your 401k without paying a penalty on top of income taxes. But there are very strict rules on what financial disasters qualify, as any experienced money manager will attest. Assuming you're not in one of those rare "non-penalty" situations, you will pay a 10% penalty on top of the income taxes you'll owe on your distribution. Take $10,000 out of your 401k before you're eligible, and you'll fork over $1,000 of it in penalties, plus pay $2,500 in taxes if you're in the 25% tax bracket. Your $10,000 withdrawal ends up only being $6,500 ultimately.
401k Distributions for Medical Hardships
The IRS allows you to take an early distribution from a 401k without penalty to pay for unreimbursed medical expenses. However, beginning in 2013, only medical expenses exceeding 10% of your adjusted gross income are eligible. Furthermore, you have to pay those expenses in the same year that you take the distribution. So if you withdraw the money in 2013, you have to pay the bills in 2013 too. Additionally, you cannot avoid the penalty on a 401k distribution for covering medical expenses if other financial resources are available. Speak with a qualified money manager about your options for addressing medical hardships.
What About Taking a Loan from a 401K?
You may have heard of people borrowing money from their 401k. Your employer does not have to allow these loans. While you won't owe taxes or penalties if you loan yourself money from your 401k, and are repaying the money (plus interest) to yourself, there is still a major risk. Should you leave your job for whatever reason, your former employer will most likely demand immediate repayment. If you're unable to repay at that time, the balance of the loan will be treated as an early distribution, with the financial penalties that go along with it.
The Better Alternative: Emergency Savings
Most people are less inclined to start an emergency savings account than a 401k. After all, 401k contributions come out of your paycheck before taxes, and many employers match a percentage of contributions. With an emergency account, you're your own money manager and nodiv matches contributions. But the tax and penalty liabilities you incur with early 401k distributions make the emergency savings account far better for meeting emergency expenses. Furthermore, if you suddenly need a big car repair or a new refrigerator, you can simply go to the bank and get the money.
Smart money managers have three to six months' living expenses put away in emergency savings, but any emergency account is better than none. Even three hundred dollars in an emergency account is $300 you won't have to put on a credit card.
It's hard to look at that hole in your roof and think of all the money sitting in your 401k. But a sharp money manager will tell you your other options are preferable to raiding your 401k. With credit cards, you can try to pay down the balance quickly. Lines of credit from your bank or credit union often have low interest rates. And if you have an emergency savings account, you have your best option for meeting unexpected expenses. The bottom line is that you should have a hands-off policy for your 401k and put money into an emergency account to minimize harm to your long term finances and maximize options for paying for unexpected expenses.
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