Q: I’m in financial trouble. Should I take out a 401k withdrawal?
This is a tough question, and the answer is generally, Not unless you truly need it. A direct withdrawal from a 401(K) before age 59 ½ is a last-resort option, with a big taxable event.
I want to distinguish clearly between 401K loans and 401K withdrawals. In this piece I’m discussing withdrawals. You can read about loans here.
Think about what happens in the 401(K). The IRS “lets” you defer salary into your account without taxation. Your employer may make matching or discretionary contributions to the account on your behalf, which he deducts from his income. Lots of tax advantages here, and the IRS wants you to keep the funds invested for their purpose: funding your retirement. Consequently, if you need to put your hands on some fast cash, the IRS doesn’t want you looking at your retirement account.
If you’re in a pinch, however, and if your employer’s plan documents allow for it, you may be able to loan your own money from your account to yourself, at interest. I’ve discussed this thoroughly here. But what if you’ve already loaned out the max, and still need money?
You may qualify for a hardship withdrawal. The IRS definition of a hardship is that the need is immediate and heavy, and that there are no other resources available. As I said, this is a last-resort option. You would have had to loan out the maximum first. If you still need funds, you apply, probably online, and spell out your financial situation to a committee, which will then approve or deny your withdrawal. If approved, you get your money.
The amount distributed becomes an immediate taxable event. This should make sense, since all money being distributed during retirement is fully taxable. If you are under age 59 ½ there is an additional tax penalty.
Here’s an example: Say you take a hardship distribution of $25,000, and that distribution puts you in a 22% tax bracket. Your tax liability ($25,000 *.22) + early withdrawal penalty ($25,000 * .10) is $8000. You lose 32% of the money off the top. This is a very expensive way to access cash.
This is life. Financial emergencies are not a matter of whether they’ll occur, but rather of when they’ll occur. That is why a big part of any financial planning engagement with a client is establishing and funding an emergency fund.
In preparing advice to someone considering a 401(K) withdrawal, I’d want to determine:
Bankruptcies happen at the margin. If you have a payment due that is $1 more than you can afford, then perhaps Chapter 7 awaits you.
Everything in financial planning revolves around cash flow management. If you have guardrails on your spending, then you are sure to fund your short-term and long-term savings goals.
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