When you’re young, saving for retirement can seem a bit daunting. It may take you several decades before you have enough money to retire. And keeping yourself motivated to save can be tough.
If you already have a 401k, you may be tempted to use that money for something else…now. If you’re in debt, have home repairs, or need cash ASAP, taking money out of 401k funds can seem like an attractive option.
According to a 2015 article by Fidelity, eleven percent of workers took out a 401k loan within the past year, at an average amount of $9,500.
But is there really ever a reason it makes sense to make a 401k early withdrawal and use that cash for something else? Let’s take a closer look.
Using your 401k to pay off debt
Taking money out of your 401k in order to pay off debt seems to make sense on the surface.
Your debt is accumulating interest and costing you money. If you have money in your 401k to pay it off, or at least lessen your debt load, why not, right?
However, the magic behind the 401k is the compound interest — or interest on top of interest — that you would earn on your funds. And if you take money out now, you’ll have to start all over again with your investments. Plus, you could lose some of the gains you’ve already made.
Instead of taking an early withdrawal from 401k, consider making a balance transfer. You can consolidate your credit card debt using a zero percent interest credit card. Then, pay off your balance before the promotional period is up.
Another option is getting a personal loan to pay off credit card debt. If the interest rate for the personal loan is lower than your credit card’s, then you can save money on interest payments. And you avoid tapping into your retirement funds.
While paying off high-interest credit card debt with a 401k early withdrawal may seem attractive, why pay for your past with funds from your future? Though it seems like the easiest way to pay off debt, Certified Financial Planner David Rae disagrees.
“When times get tough people often make the big mistake of pulling money from retirement accounts to pay off debt, or other bills,” says Rae. “If your situation is truly dire, retirement accounts are often protected in bankruptcy or from creditors. But once you’ve pulled money out, it’s fair game.”
401k early withdrawal for emergencies
Emergencies usually happen when you least expect them, and at the most inconvenient times. Whatever the situation may be, it can be tempting to make a 401k early withdrawal to pay for them.
However, taking money out of 401k or retirement savings accounts can mean paying extra in taxes. Not to mention a withdrawal penalty.
“If you take money out of your 401k you will owe income taxes and a 10 percent penalty if you are under 59 and a half,” Rae says.
If you really don’t have the cash on hand for emergencies, you may want to consider using a credit card instead. Especially if you can pay it off before interest accrues. Or, take out a personal loan at a low-interest rate, which may take a few months or even a few years to pay back.
While these options may be better than using your retirement funds, they are still less than ideal. Cash is king. So if you don’t have any money saved up for the unexpected, there’s no better time than now to get started.
An emergency fund can be three to six months’ worth of expenses in a separate, high-yield savings account — and only used for emergencies.
401k rules for early withdrawals
After saving your hard-earned money for your future, it may seem like no big deal to borrow money from your retirement account. It is your money after all.
But there are real consequences to a 401k early withdrawal. As noted above, taking money out of 401ks can lead to a penalty fee of 10 percent as well as additional income taxes.
Not only that, it may be harder to get back on track once you’ve borrowed. Last year, Fidelity noted in its analysis that half of investors who borrowed from their 401k ended up borrowing more later on.
Aside from these 401k rules, you also want to make sure you like your job and plan on staying awhile as you pay back your 401k loan. Typically, you need to repay your balance within two months of leaving the company who offers the retirement plan.
If you think you are at risk of being laid off, taking on a 401k loan could be too risky.
Avoid 401k early withdrawals at all costs
“I really don’t think there are very many scenarios when pulling money from your 401k makes sense,” says Rae. “If you are able bodies and working you really should explore other options.”
In other words, tapping your retirement funds should be an absolute last resort. Try and look into using your savings, credit cards, or other types of loans first before touching your 401k.
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