Retirement: Taking your money out
from 401(k)
Because company retirement plans are designed to help you save for
retirement, tax laws require that you pay an early withdrawal penalty for most
withdrawals made before age 59 1/2. This penalty is intended to discourage early
withdrawals and to help you save for your retirement. So, in addition to the
ordinary income tax that you would pay on any pre-tax contributions and earnings
you may also owe a 10 percent penalty on an early withdrawal. You can take out
your money if it qualifies as a hardship withdrawal. Below
are four expenses that qualify as an immediate and heavy financial need.
- Paying for medical expenses that
exceed 7.5 % of your adjusted gross income. The expenses can be for you, your
spouse, your kids, or other dependents.
- Paying for tuition, related
educational expenses, and room and board for post-secondary education. These
can also be for you or your dependents.
- Down payment for purchasing a
principal or primary residence (not a vacation home).
- Preventing an eviction or
foreclosure on your home.
You must use up all your other
financial resources, including insurance and a loan from your plan before you
can take a hardship withdrawal. You may also still owe income taxes and a
possible 10% early withdrawal penalty if you are under 59 1/2 when you file your
annual income tax return. Therefore, make sure you really need the money before
you take a hardship withdrawal.
Borrowing from your 401(k):
Another way to take your money out of your account is to take a loan from your
401(k).
If your plan allows for loans (not all plans do), the most you can borrow is the
lesser of 50 percent of your vested balance or $50,000. Any loan balances over
the previous 12 months may reduce the amount you have to borrow. When you take a
loan from your account, you actually take money out of your account, with a
promise to repay it. You pay your account back the amount you borrowed plus
interest, through automatic deductions from your pay or bank account, or through
coupon payments. The interest you pay your account is not tax-deductible and is
paid with after-tax dollars. As long as you repay your loan on time, you won't
be subject to withholding taxes or penalties, as you would if you withdraw from
your account before retirement.
There are some additional things to keep in mind when considering taking a loan.
First, check with your employer to find out what the rules are for repayment if
you leave the company before repaying your loan in full. If you decide to leave
your employer, you must repay your loan in full immediately or within a certain
amount of time (depending on the provisions of your plan). If you are under age
59 1/2 and you do not repay your loan within this certain time frame, the
pre-tax portion of your loan is then considered an "offset distribution." This
distribution is subject to a 10 percent early withdrawal penalty as well as
current income taxes unless you rollover the outstanding balance to an IRA or
another employer-sponsored retirement plan within 60 days. Some employers treat
loan defaults differently, and some charge fees for taking loans.
Second, you should note that while it may seem like a loan is tax-free, it
isn't. Over time, you will pay taxes on the money twice. First, loan repayments
are deducted from your paycheck after income taxes have been withheld, then as
repayments are reinvested in your account they are characterized as pre-tax
money. So, when you withdraw from your account, you will pay taxes on the money
again.
Lastly, consider the possible long-term effects a loan can have on your account
balance. Although a loan may be a practical option when you need financial
assistance, you could miss out on the full growth potential of your principal
over the long term. In other words, the money you take out of your account
immediately loses its earning potential. And while you're paying interest on the
loan, it's important to remember that the interest is coming out of your own
pocket.
Next-->>
Frequently Asked Questions
on 401k
Related Articles:
All about 403(b)
Related Links:
Table of Contents:
-
What Are Retirement Accounts?
-
Employer Based
Retirement Plans
-
401(k) Plans
-
Individual Retirement Accounts (IRAs)
-
Roth IRA
-
What is a Rollover IRA?
-
Converting and
Recharacterizing of an IRA
-
Education IRA & SEP IRA
-
Self Employed Retirement plan: Keogh
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