The Risk of Tapping Your 401(k) for Emergencies
Egads! A financial emergency occurred. Maybe you left your roast in the oven too long and set the kitchen on fire. Now your kitchen is ruined. On top of that, your homeowners insurance won’t cover the full cost of the damage and you have a deductible to pay before the insurance will even kick in.
But what if… you could withdraw money from your 401(k) retirement account to pay for the deductible and cost of repairs? That is certainly an idea, especially if you can avoid taking out a personal loan or racking up credit card debt to cover the extensive expense of a new kitchen.
However, tapping into your retirement funds may not be the delightfully devilish idea you would hope for. Read on to find out whether withdrawing from your 401(k) early would be an unforgettable experience in a positive or a negative sense.
How does a 401(k) work?
401(k) plans are retirement accounts offered to employees as part of a benefits package. Created as part of the Revenue Act of 1978, 401(k) accounts allow employees to divert a portion of their pretax income from each paycheck to an investment account. Employers that offer 401(k) plans tend to match their employees’ contributions up to a certain percentage of their paycheck.
Even though traditional 401(k) contributions are made before income tax is taken out, there is sometimes the option of a Roth 401(k), which was introduced in 2006. Unlike traditional 401(k) accounts, you do have to pay taxes on the amount that goes into a Roth 401(k). The advantage comes when you choose to withdraw the money, as you will not have to pay those taxes later on. Whether you should contribute to one or the other — or to both and in what proportions — depends on if you expect to make more money later in your career and what you predict will happen with tax rates and the market.
While the intended use of a 401(k) is to wait until retirement to start withdrawing from it, it is possible to withdraw from it earlier — however, that possibility comes with an additional price tag.
Is it a good idea to withdraw early?
Every expert we spoke to was generally against the idea of withdrawing early from your 401(k) if you can help it.
“Withdrawing from your 401(k) should generally be considered a last resort,” warns Leslie H. Tayne Esq., Founder and Head Attorney at Tayne Law Group. Since the money in a 401(k) plan grows with compound interest, withdrawing money early will have a long-term impact on the total amount you will eventually earn. You are going to lose out big time. “Additionally, you’ll be charged a 10% penalty and pay [income] taxes on what you withdraw. And to replace those funds, you may be taking [money] from post-tax income, which means you are paying more to replace the money.”
Still, there are some circumstances in which it may be the best possible option.
“Perhaps you have a tax debt or a large debt with high interest that you need to resolve and restore your credit,” Tayne says. In this situation, she says it may make sense to borrow from yourself and pay yourself back, but it would be important to explore the long-term cost of this decision and how it compares to alternative options. “It should not be a knee-jerk reaction to any problem, but a well-thought-out option with the help of an expert to go over all scenarios.”
Even if you are able to replenish the money you took from your 401(k) at a later date, it will likely be with post-tax funds and it will have missed some of the time to mature.
If withdrawing from your 401(k) should only be a last resort, what might some of the earlier resorts be?
- What can I cut from my normal budget and spending?
- Can I earn extra income from a side hustle or working more hours?
- Are there friends or family who can lend me some money?
- Are there any financial aid options to help with the emergency?
“Try exploring other options available to you before you start borrowing from your future,” Watson says. While reaching out for help may be humbling, it is better than losing out on your retirement.
“Borrowing from a family member, especially if you can do so at zero interest, can be an excellent option” Tayne says. “However, it is best to have a written agreement to ensure that both parties’ interests are taken care of.”
She also advises trying to work out a deal with your creditors: “If you have a specific emergency, you may be able to get credit or decide on a payment plan with the medical provider, car repair service, dentist, etc. Note that credit through a third party and negotiating a payment plan are two different options, but both can be effective ways to pay off the emergency without the cost of tapping into your 401(k).”
Withdrawing from your 401(k) early is almost never going to be the best choice. But if you have exhausted every other financial option, it may be something to consider.
Ben Watson, CPA is the virtual chief financial officer of DollarSprout.com and founder of Fiscal Fluency, a personal finance and business coaching company. He equips small businesses and entrepreneurs with the skills and accountability to manage their businesses with confidence rather than fear. He’s also the co-creator of the Business Launch Kit—an online course with simple-to-follow steps of how to create your own business without making a mess. Follow him @DollarSprout.