Avoid taking a 401(k) withdrawal if you can

One of the realities of life is that you never know when it might throw you a curveball. Take, for example, the Covid crisis, when millions of workers were laid off or had their hours or pay reduced – in many cases permanently.

But a pandemic isn’t the only thing that can cause you to lose your job. And if you do, you’ll still have to pay for life’s necessities – housing, utilities, groceries, medical expenses and more, while still saving for retirement.

In this scenario, it might be tempting to tap into your workplace retirement plan to cover these needs. However, 401(k) withdrawal rules say that if you take money out of your account before age 59½ you are subject to a 10% penalty, and you will have to pay income tax on the distribution.

But you can avoid the 401(k) withdrawal penalty, and the taxes, if your retirement plan allows you to take out a loan against your retirement funds instead. Yet, people often make this decision without understanding the consequences of borrowing from a 401(k).

Taking a 401(k) withdrawal is a life-changing decision because it can seriously harm your ability to achieve financial security in retirement. 

Let’s say that Mary, age 45, has $100,000 in her 401(k) and takes out a $50,000 loan, but never repays it. If she hadn’t borrowed that money from her plan, by age 70, her assets would have grown to $1.2 million (assuming a 7.5% rate of return, a 6% annual contribution rate and 3% employer match). But if Mary defaulted on the loan, at age 70, she would have only $900,146. That’s 25% less.

Borrowing from your retirement account is never ideal, but life sometimes makes it unavoidable. For example, you might need money for medical care, to avoid eviction, to buy a car or pay for car repairs so you can drive to work.

Those are legitimate and necessary expenses, but unfortunately, people often have frivolous or at least questionable reasons for accessing their retirement savings early.

Nonessential reasons can include paying down credit card debt, vacations, weddings and simply “fun spending.”

And once their “lifeline” is gone – because retirement funds are depleted or borrowing limits are reached – many people find that their financial stress only worsens.

To make matters worse, all too often, those who take a 401(k) withdrawal may not understand these critical points:

• The term “borrow” is really a misnomer. In reality, the “loan” is a withdrawal of funds from a 401(k) plan.
• They may have to pay fees to obtain the loan.
• They will pay interest while repaying it.
• And they can also incur a penalty if they don’t repay the loan on time.

In order to “fund” this loan, mutual fund shares in the account are sold. Which means those shares no longer exist, causing the borrower to miss out on any subsequent return if those shares rise in value.  This just adds to the potential missed gains opportunities during the repayment period.