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The Pros and Cons of Tapping into Your 401(k) in Times of Need

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 account balance and repay yourself 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 those of 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; therefore, you are paying taxes on this money before you can 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 employed and then terminate employment, your plan may require you to pay back the loan quickly, and that may cause 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. While the CARES Act provided specific guidelines for coronavirus-related hardships, it's crucial to check with your plan administrator for current hardship withdrawal options as they may have been updated or expanded based on more recent legislation, like the SECURE 2.0 Act. In the meantime, hardships are only available if the plan allows it—or your employer amends the plan to allow them—and the plan administrator must approve an application with proof of hardship.

Pros

  • Funds can be available to the saver 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; 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 savers to withdraw from their retirement plan even if they cannot satisfy the hardship standard while they’re still employed by the business. 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

  • Savers 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 savers 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.