Understand when you can take a 401(k) or 403(b) withdrawal and how much it'll cost you.
Money Girl
190 MG Taking a 401(k) Withdrawal
Curious how equity compensation can help build employee financial confidence and move your business forward? Tune in to the latest episode of Morgan Stanley at Work's "Invested at Work" podcast where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandley.com/investedatwork or stream on Apple or Spotify. Because we believe that when employees thrive, your company thrives too. Again, visit morganstandley.com/investedatwork to listen today. Hi everyone and welcome back to Money Girls quick and dirty tips for a richer life. I'm Laura Adams. Many people are tempted to take money out of their work retirement plan when they hit a financial rough patch. I get plenty of emails from listeners asking my opinion about whether I think it's okay. Before you pull the trigger and take an early withdrawal from a 401k or a 403b, it's really important to fully understand the rules and penalties. I'm going to tell you when you can take a withdrawal and try to persuade you to never take money out of a retirement plan if you can help it. First, let me back up and briefly explain 401k and 403b retirement plans. They're offered by employers so workers can easily save money for retirement. One of the best features of these plans is that many employers match all or a portion of an employee's contributions by depositing additional funds into their account. Most corporations can set up a 401k plan, but a 403b is available for certain organizations such as nonprofits, public schools, hospitals, and churches only. There are also 457 plans for state and local government workers and a thripped savings plan for federal employees, but they operate under slightly different rules. Many people mistakenly believe that they can take money out of a 401k or a 403b at any time and for any reason. If you're accounting on using 401k funds to pay for your next vacation or to buy a car, I hate to disappoint you, but it isn't allowed. You can only take money out of one of these plans when you reach the age of 59 and a half, qualify for a hardship, leave the job, become disabled, or die. Workplace retirement plans have very strict rules about when you can take money out and some plans don't allow for any kind of hardship withdrawal. The IRS specifies that taking a hardship distribution can only be allowed in the following situations to prevent eviction from or for closure on your primary residence, to purchase a primary residence, to pay for repairs for your primary residence, to pay unreinversed medical bills for you or your family, to pay funeral expenses, or to pay the cost of higher education for yourself or for someone in your family. The amount you can withdraw from your retirement plan for a hardship is limited to your total contributions, which is also known as your elective deferrals, and generally can't include any matching funds or earnings on your account. Some plans require that you first exhaust all your other options, such as applying for a commercial loan, liquidating assets, or borrowing from your retirement plan before you can take a hardship withdrawal. When you take a hardship distribution, you can't just put the money back in at a future date because it's not a loan. Contributions to workplace plans can only come from payroll deductions. By the way, I'm going to cover the topic of taking loans from a 401k or a 403b in next week's show. I recommend that you never take money out of a retirement plan if you can help it. There are four reasons why tapping your 401k or 403b is a bad financial move. Number one, there's an automatic 10% penalty if you're younger than age 59 and a half. Number two, you lose out on years or decades of account growth. Number three, there's typically a six-month waiting period where you can't make new contributions. And four, retirement accounts are protected if you or your company declare bankruptcy. Okay, here's more about those four points. When you take money out of a retirement account due to a hardship before the official retirement age of 59 and a half, it's called an early withdrawal. The government discourages you from doing that by imposing a hefty 10% penalty on amounts that you cash out, except in a few situations, such as when you have a court order to split up the account due to a divorce or you become disabled. In addition to the penalty, you also have to pay income tax on any amount you withdraw that wasn't previously taxed. Here's an example of how expensive it is to take an early withdrawal. Let's say you've contributed $25,000 to your 401k and you want to cash it out to buy a home. If your average tax rate is 28%, the 10% penalty makes a total amount you'll owe the IRS 38% or $9,500. That only leaves you with $15,500. I love learning and anything that makes learning easier. If you're a parent and your child needs some homework help, then Ixcel is a right for your family. Ixcel is an online learning program for kids covering math, language arts, science, and social studies. Ixcel has interactive practice problems for topics from pre-k to 12th grade and everything is organized by grade and subject. As kids practice, they get positive feedback, awards, and explanations for wrong answers. Ixcel figures out what your kids need more help with and recommends more topics to practice. Their videos, lessons, sample problems, and learning games too. One subscription to Ixcel gets you all subjects and all grade levels. Membership started just $9.95 a month. It's no wonder Ixcel is used in 95 of the top 100 school districts. 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If you think taking an early withdrawal sounds expensive on the front end, they're outrageously expensive in the long term. The opportunity cost, which is the benefit you would have received if you hadn't taken an early withdrawal, is massive. That's because you lose out on all the potential investment gains and tax benefits that would occur over the long term. Remember that once you take a hardship withdrawal, you can't just repay it to your retirement account. Another rule that I mentioned about taking a hardship withdrawal is that you're usually subject to a six month waiting period where you can't make any new contributions. So not only do you miss out on adding to your retirement nest egg, but you don't get additional funds that your employer might offer in the form of a matching contribution. Going back to my previous example, let's say you decided not to cash out your $25,000. If you didn't contribute another dime to the account and had 20 years until retirement, you'd have close to $83,000 in the account even with a modest 6% annual return on your investment. If you contributed $250 a month for those 20 years and got the same annual return, you'd have over $198,000. And if your employer kicked in an extra $125 a month in matching funds, you'd really be sitting pretty with close to $257,000 at retirement. So your choice is to take a withdrawal that will net you a mere $15,500 after the penalty in taxes, or to resist the temptation to cash out and to potentially amass hundreds of thousands of dollars for a secure financial future. Try out the 401(k) savings calculator at bankrate.com to find out how much you could accumulate for your dream retirement. The last reason I mentioned for not taking a withdrawal has to do with bankruptcy. One of the benefits of a 401(k) and 403(b) retirement account is that they're protected by federal law if you or your company declare bankruptcy. That means dipping into them should be done only after you've consulted with an accountant or even with a bankruptcy attorney. It would be foolish to deplete your retirement funds when your creditors aren't legally allowed to touch them. If you cash out your retirement and then end up declaring bankruptcy later on, you may have spent your retirement money for nothing. So remember that a hasty withdrawal could be devastating to your future financial security. If your workplace retirement plan offers a loan as an alternative to taking a hardship withdrawal, that may be a better option. Join me again next week for more about taking loans from a 401(k) or 403(b). Here's one more quick and dirty tip that can turbo-charge your retirement nest egg. When you leave a job, never cash out your retirement account. Instead, roll it over into an IRA or into the retirement plan at your new employer. That leaves your money invested and working for you, so it'll be there when you need it during your retirement. If you're not already subscribed to the MoneyGirl podcast on iTunes, it's easy, free, and doesn't even require an iPod. You get each new episode as soon as it's released on the web. You can also get updates about new shows and more money tips from the MoneyGirl Facebook page. Just go to the MoneyGirl section at quickanddirtytips.com for links to everything that I've mentioned and lots more stuff. While you're there, subscribe to the MoneyGirl newsletter for extra content that you won't find on the blog or podcast. As always, email your questions or comments to me at money@quickanddirtytips.com. Are you feeling overworked and overwhelmed? You need to pick up a copy of Steven Robbins' new book, Get It Done Guys 9 Steps to Work Less and Do More. It covers all the big things that cause you to fall behind on your goals. You'll learn how to deal with distractions and get techniques to stop procrastinating. Get it done guys 9 steps to work less and Do More is available in paperback, as an ebook or as an audiobook. Pick up or download your copy today. I'm glad you're listening. Cha-ching. That's all for now. Courtesy of MoneyGirl, your guide to our richer life. Curious how equity compensation can help build employee financial confidence and move your business forward? Tune in to the latest episode of Morgan Stanley at Work's Invested at Work podcast, where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandley.com/investedatwork or stream on Apple or Spotify. Because we believe that when employees thrive, your company thrives too. Again, visit morganstandley.com/investedatwork to listen today. [BLANK_AUDIO]