Taking Money out of a 401K

[umsami]

OK... I've always been told this should be the absolutely last resort. Does anybody have any thoughts on when it is OK? Like is it OK to pay off credit card debt?? What sort of penalties does one incur?

Thanks

[Julie Rains]

Typically you will pay 1) regular taxes on the amount you are withdrawing and 2) 10% penalty for early withdrawal. You should have received a tax deduction on the amount of your contributions (your Adjusted Gross Income -- AGI was lowered) so now the government wants the tax break back basically; the penalty is a disincentive (the government wants you to save for retirement so to encourage you from taking money out, you get a penalty).

You might consider 1) stopping your 401(k) contributions for now in order to pay off cc debt and 2) opening a Roth account. You don't get a tax deduction for the Roth contributions but you also don't have to pay taxes on withdrawals of the original amount (not earnings) if you decide to withdraw the money later. The Roth money is there and you can decide whether you spend it down the road or let it be part of your retirement funds. You could also borrow from your 401(k).

[Jeremy]

It should certainly be a last resort, but your question leaves one issue open. Are you talking about taking money out of a 401k from a previous employer, or via a loan through a 401k you currently have.

Generally speaking, you can't just take money out of your active 401k with your current employer unless they provide and you qualify for certain hardship provisions. They may however offer a loan provision. As Julie said, when you simply "cash out" or otherwise withdraw money from your 401k (not a loan), it will be treated as ordinary income, plus an additional 10% penalty. So for most people, this means you're giving up somewhere around 30% right off the top.

But if you are talking about just taking a loan from your existing employer, you actually wouldn't immediately be subject to taxes or penalties. Since it is a loan, you are expected to pay it off through payroll deductions over a period of 1-5 years. Because of this, it isn't treated as a withdrawal and thus you aren't taxed or assessed a penalty as long as you repay it in the agreed to time frame.

Even so, this should be treated as a last resort for a number of reasons. First, you're just setting yourself back in terms of long-term savings. Yes, you do eventually put it back into your account with some additional interest, but you're still taking money out of the account that could otherwise continue to compound and grow. In addition, you're repaying the loan with after-tax money, so you'll be essentially taxed twice on a portion of the loan repayment. And finally, if you were to leave your employer prior to repaying the loan, you could be faced with having to repay the outstanding balance, or else it would be treated as an early distribution that would then be subject to taxes and the 10% penalty. In some cases an employer may offer a coupon book to allow you to repay the loan after your employment has ended, but in many cases they will require full repayment within 60 days.

While taking a loan is a bit better than just cashing out all or a portion of an old 401k, it still should be used after all other options are exhausted. If you can find ways to accelerate your debt payments without tapping into those retirement assets, you should do that first.