Today’s challenging economic environment can create a cash crunch, as some people may face huge expenses, such as unanticipated medical costs or the possibility of a home foreclosure. In many cases, credit card debt limits have been reached, and with declining home values, home equity loans may not be an option to provide quick cash. When situations like this occur, many are tempted to rely on what may appear to be the most readily available source of money — their 401(k) plan. Hardship withdrawals from workplace retirement plans are drawing more interest from investors.
While 401(k) dollars can be tapped for emergency purposes, the assets are not as liquid as you might expect. Taxes and penalties may apply if you withdraw funds early, and there is little flexibility to avoid it. For instance, if you are in the 25 percent tax bracket, a withdrawal of $10,000 from your 401(k) will net you $6,500 in available cash after you pay taxes and a 10 percent penalty.
Because of that, and due to the fact that you should be doing all you can to preserve your retirement portfolio, it may be best to avoid early withdrawals from your 401(k). After all, once retirement comes, you may not have opportunities to add more to your nest egg. Early withdrawals today could increase the risk that you may outlive your savings in retirement.
Timing not the best
If your portfolio is performing somewhat in line with the stock market, selling during a market downturn is not typically recommended. For most investors, this has been a challenging period where the value of their 401(k)s has been declining due to the difficult market environment.
It is also important to note that withdrawals can only occur under specific circumstances. According to the IRS, an early withdrawal from a 401(k) qualifies as a hardship withdrawal if you are:
• Paying unreimbursed medical expenses
• Purchasing a principal residence
• Paying college tuition costs for certain family members
• Making payments to avoid a home foreclosure or paying for home repairs
• Covering costs of a funeral
Even if you meet these conditions, you will not avoid paying tax and penalty on your withdrawals.
Find other options
In order to preserve the integrity of your retirement plan and avoid the impact of taxes and penalties, you should consider alternatives to hardship 401(k) withdrawals in order to meet short-term financial needs. One option is to take a loan from your 401(k) plan. Check with your plan sponsor (your employer) to see if loans are an option within your plan. At the same time, use caution. When you borrow from your 401(k), you repay the loan at interest rates that are often tied to the current prime rate, but the amount you took out of the account is no longer generating returns from your investment portfolio. In addition, an important caution is to pay back the loan as quickly as possible. If your employment should be terminated, the unpaid portion of the loan is treated as a distribution, subject to taxes and possible penalties for early withdrawals.
Your best bet to meet current cash needs is to try to discover another alternative that allows you to keep your 401(k) intact for its primary purpose — funding your retirement.
This information is provided for informational purposes only and is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor.
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