The Ins and Outs of Tapping Your Retirement Account Early

by Mark Miller / Reuters

401(k) accounts are not designed as piggy banks to be tapped for nonretirement expenses. But stuff happens.

Since the Great Recession, loans from 401(k) accounts have been rising. Some 17.6% of plan participants had loans outstanding last year, compared with 15.3% in 2008, according to the Investment Company Institute (ICI). A much smaller number of 401(k) participants (1.3%) took hardship withdrawals last year, according to the ICI.

The loan numbers reflect the financial pressures facing so many households. A recent survey by the Pew Charitable Trust found that 60% of U.S. households experienced a financial shock in the past 12 months. This was typically lost income due to unemployment, illness, injury, death or a major home or vehicle repair.

When trouble strikes, backup emergency cushions are often glaringly absent. Lower-income households (income below $25,000) had enough savings to replace only six days of household income. Even households with more than $85,000 say they can replace just 40 days of income from savings, Pew found.

Plan sponsors are not required to allow loans or hardship withdrawals, but about 90% do, said Lynn Pettus, national director of the employee financial services practice at Ernst & Young LLP. "Most of them think flexibility is necessary because at the end of the day employee is putting away their own money for retirement," she said.

But employers and retirement policy experts worry about early withdrawals.

This kind of account leakage is one of the culprits behind the anemic retirement savings that so many workers must eventually confront. In addition, pre-retirement withdrawals come with plenty of downside and risk, ranging from lost investment returns to taxes and penalties.

Retirement accounts are not a convenient way to obtain cash in an emergency, because it can take time to access your funds. "As soon as administratively possible is the norm" said Pettus. "That said, we have seen 10 business days, 15 business - even 90 days."

Loans

Your workplace plan can allow you to borrow up to half of your plan balance, up to a maximum of $50,000. There is no 10% early withdrawal penalty, since you are borrowing, not withdrawing, funds. There is no credit check, and you can repay the loan through payroll deductions. Interest rates typically are modest, often around 5%, and bear in mind that you are paying interest to yourself.

A big downside: Foregone investment returns on the borrowed funds are gone forever. Moreover, your repayments of principal and interest on the loan typically come from after-tax dollars.

When you withdraw that money later on in retirement, the interest effectively is subject to taxation a second time (that does not apply to the principal, since when you take the loan it is not a taxable distribution).

Also ask yourself if you are sure you can repay the loan, which typically must be repaid within five years. Should you default, the outstanding balance will be subject to the 10% early withdrawal penalty and any regular income taxes owed. On a $20,000 balance, you are facing a $2,000 fine and another $3,000 in income taxes (assuming a 15% tax bracket). That can really hurt if you already are experiencing financial stress.

Hardship Withdrawals

Retirement plans are not required to offer hardship withdrawals, but if they do, the need must be based on a demonstrated "immediate and heavy financial need," according to Internal Revenue Service (IRS) rules. The withdrawal must be used to satisfy that specific financial need, and cannot exceed the amount of the demonstrated need. There is no guarantee the withdrawal will be approved.

Examples of qualifying needs include certain medical expenses, costs related to buying a home, college tuition, payments to avoid an eviction or foreclosure, burial expenses and home repairs.

This really is a last-resort measure, because the downsides are big. You have permanently reduced the size of your retirement account, and foregone future tax-deferred growth on those dollars. The plan sponsor can prohibit additional contributions for six months after the withdrawal, along with any matching contributions.

You will owe income taxes on any amount withdrawn, along with the 10% federal penalty if you are under age 59-1/2. Withdrawals are exempt from the penalty under certain circumstances. The IRS publishes a chart detailing withdrawals that may be exempt from the penalty.

So which option is better - a loan or a hardship withdrawal - in case stuff happens? A loan, said Pettus. "It's always better, because you pay yourself back."