Every 401(k) plan is supposed to serve a specific purpose. It’s a retirement account that can give you a source of income when you leave the workforce. As a result, a 401(k) isn’t technically designed with early withdrawals in mind. However, that doesn’t mean you can’t pull some of the money. If you are wondering whether that’s a smart move, here are the pros and cons of an early 401(k) withdrawal.
401(k) Early Withdrawal Rules
Before you focus on the pros and cons of making a withdrawal, it’s important to understand that they are only allowed under specific circumstances. There are limits that the IRS put in place, and you have to abide by those rules.
If you aren’t at least 59 ½ years old, as far as the IRS is concerned, you can only take money out of a 401(k) if there is a financial hardship, employment termination, termination of the retirement plan, disability, or death. However, it’s also important to note that your employer can impose additional restrictions, limiting your ability to pull funds even further.
The Pros of an Early 401(k) Withdrawal
Usually, the only pro of making an early 401(k) withdrawal is it may allow you to handle a financial situation that would otherwise be devastating. If you are experiencing a significant hardship, not having access to the money could result in serious consequences.
For example, if an unexpected medical emergency resulted in massive hospital bills, an inability to pay could be incredibly problematic. The account could end up in collections, destroying your credit. You could get sued for repayment or have to file for bankruptcy to free yourself from the debt.
If you have enough in your 401(k), you might be able to use the money to handle that bill. For many, that may make it beneficial enough.
The Cons of an Early Withdrawal
There are penalties for early 401(k) withdrawals, even under circumstances where they are allowed. First, money that goes into a 401(k) is pretax. As a result, when you pull the cash, you’ll owe taxes on it. Depending on your bracket, that could be a significant cost.
Additionally, you could owe a 10 percent penalty for making the withdrawal. That isn’t always the case, but it could occur. As a result, it’s important to review the IRS rules to see whether it applies.
Finally, when you take money out of a 401(k), it diminishes your savings potential. That money was growing tax-deferred. By removing it now, you are taking its earnings potential away. If you are younger, you are likely reducing the long-term balance of your account substantially.
This is especially true if your account has contribution rules tied to an early 401(k) withdrawal. Some accounts bar those who remove money from making new contributions for a period, preventing them from bolstering their balance for a time. The long-term value of the account is harmed as a result.
Alternative to an Early 401(k) Withdrawal
If you need to tap the value of your 401(k), you don’t necessarily have to make a withdrawal. Instead, a 401(k) loan might be a possibility. Per IRS rules, you can borrow the lesser of $50,000 or half the account value. With this approach, you don’t have to deal with penalties or taxes on the money when you pull it. Plus, the interest you pay goes into your account. However, the money you borrow won’t be eligible for any market gains, so that could reduce its earnings power while it is being repaid.
Additionally, you need to know that some employers don’t allow 401(k) loans. They aren’t required to allow this kind of financing, even though it isn’t against IRS rules. However, if yours does, it could be worth exploring as it might work out better for you than an early 401(k) withdrawal, depending on your situation.
Can you think of any more pros or cons of an early 401(k) withdrawal? Share your thoughts in the comments below.
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