Billy Jones borrowed $10,000 from his 401(k), cutting his retirement savings in half. He felt like he had no other choice. Although employed full-time, he and his wife couldn’t keep up with their monthly expenses after MasterCharge reduced the limits on their credit cards. As banks around the country tighten their lending standards due to a faltering economy and food and gas prices continue to climb, more and more people are resorting to the same measures as Billy and his wife. They are drawing out of their retirement accounts just to get by and help make the mortgage payments and put food on the table.
This is a worrisome practice to financial planners as it means people are using their retirement money now and lowering their standard of living when they retire. Large plan administrators like Great-West and Fidelity are seeing big spikes in hardship withdrawals and loan requests. In the past, these numbers traditionally varied little. The Joneses also sold a diamond ring and some camera equipment and are trying to get rid of their expensive car lease. They are hoping to pay off their 401(k) loan in two years.
If you’re thinking of making the same decision as the Joneses and contemplating dipping into your 401(k), be aware of some of the risks involved.
At 40 years old, if you borrow half your 401(k) savings and stop paying into your account for 5 years, you risk losing nearly a fifth of what you would have saved by retirement. If you take a loan but repay the loan in its entirety and continue to pay into your 401(k) account while you are also paying the loan back, you will achieve 99% of your original retirement income by the time you reach 62 years old. If you take a loan and repay the loan but STOP paying into your 401(k) account for 5 years while you are paying the loan back, you will only achieve 82% of your original retirement income by age 62. Loans from 401(k) plans that are repaid suffer no tax consequences, but if you default on the loan and are unable to repay it, you then become liable for the tax penalty on the money you withdrew.
Dipping into your 401(k) for a hardship withdrawal that is not paid back can carry tax risks because hardship withdrawals are taxed as income and are subject to a 10% penalty if taken when you are under age 59. Because dollars you pay into your 401(k) account are pre-tax, meaning they are subtracted from your paycheck before your tax is calculated, they become taxable when you withdraw the money. So if you are in a 25% tax bracket and you are younger than 59 when you withdraw the money, you pay 25% tax plus the 10% penalty—you lose 35% of the money you withdraw. For example, if you withdraw $10,000, you will lose $3,500 of that money.
Most companies who offer 401(k) plans for their employees limit hardship withdrawals to the categories stipulated by the Federal government, i.e., medical expenses, purchase of home, foreclosure or eviction prevention, repair of storm damage, tuition payment, and funeral expenses. But even if your needs fit into one of these categories, you will still be charged the tax and penalty if you take a withdrawal. In addition to the taxes charged, many companies prevent employees from resuming 401(k) contributions for at least 6 months after taking a withdrawal.
Many people think they will pay back the withdrawal through increased contributions once hard times have passed, but unfortunately this optimistic attitude doesn’t always materialize into reality. If you are able to find a way to survive your financial difficulties without taking a withdrawal from your 401(k), research has shown that you will have 13% more in retirement funds than those who took a withdrawal.