The Pros and Cons of Tapping into Your 401(k) in Times of Need
These are uncertain times, at best. And for those of you diligent enough to be saving for your retirement, the volatile stock market has become particularly unsettling. History has shown the best course of action is to take no action at all, so if that’s a viable option, you may want to forget your password for a few months, focus on staying healthy, and revisit your retirement plan assets at a less humbling time. However, we recognize that isn’t a realistic option for everyone. Should you find yourself in a more dire situation, here are the options as they pertain to your 401(k) as well as the various points to consider before making any short-term decisions.
Temporarily Discontinue or Reduce Deferrals
If immediate cash flow is more important to you than long-term savings, you should have an easy way to change the amount you contribute each pay period to your retirement plan.
Loans
If your plan allows it, you may borrow from your own account balance and pay yourself back through loan repayments via a payroll deduction. If your employment terminates, most plans permit loans to be taken soon after separation of employment.
Pros
- Funds can become available in as little as seven business days.
- Loan amounts are not subject to taxation and interest rates are likely lower than credit cards.
Cons
- You will be double taxed on the loan repayments. While loan amounts aren’t taxable, loan repayments are made on an after-tax basis and therefore, you are paying taxes on this money before you have the chance to pay it down. Additionally, if you’re using a traditional 401(k), you will be taxed on this money again when you take your distribution from the plan.
- If you take out a loan while you’re still employer and then terminate employment, your plan may require you to pay back the loan quickly and that may cause a financial hardship.
Hardships
If you find yourself in a time of financial hardship (defined as an immediate and heavy financial need – medical expenses, burial expenses, to avoid foreclosure on the primary residence), you may be able to withdraw funds from your plan without facing tax penalties. We are closely watching whether the government will permit hardship withdrawals to be made more easily in today’s unique environment. In the meantime, hardships are only available if the plan allows it – or your employer amends the plan to allow them – and an application with proof of hardship must be approved by the plan administrator.
Pros
- Funds can be available to the participant within ten business days once your provider receives all supporting documentation in good order.
Cons
- Once the hardship is taken, there is no option to contribute it back into the plan and, therefore, any losses are locked in.
- You may be required to take a loan before you can receive a hardship distribution.
- Taking any money out will reduce the amount you will have at retirement, not to mention that you lose any interest and dividends you earned on the amount withdrawn.
In-Service Distributions
Some plans offer an opportunity for participants to withdraw from their retirement plan even if they cannot satisfy the hardship standard and while they’re still employed by the plan sponsor. There may be an age requirement to access funds from a safe harbor plan, so be sure to check your plan to confirm whether you qualify for this type of withdrawal.
Pros
- Participants can generally receive funds from their account within ten days of the provider receiving the request.
Cons
- As with a hardship distribution, there is no option to contribute this withdrawal back to your plan so you are locking in market losses.
- Withdrawals reduce the amount you will have at retirement, not to mention that you lose any interest and dividends earned on the amount withdrawn.
- Some in-service withdrawals may be taxed, especially for participants younger than age 59 1/2.
Please note that there is some talk of forgiving certain penalties in light of the current situation. We will keep you updated on any relevant changes.
Vestwell is not a law firm or tax advisor. Participants may wish to consider hiring their own professional before making any changes to their retirement plan, as there could be tax consequences and other adverse impacts on their retirement plan.
