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If you are fortunate enough to have a 401(k) through your employer, accessing those funds prior to your retirement may seem enticing. A recent analysis of 401(k) plans in America showed a shocking increase in new loans and hardship withdrawals taken in 2023. Over the past year, the proportion of workplace savers taking a loan went up by 14%, and the proportion of workplace savers taking a hardship withdrawal went up by 46%. Dipping into your 401(k) plan is generally a bad idea. Continue reading and check out our recent YouTube video on this subject: Unlock Your Financial Future: Avoid These 401k Blunders to learn more.
The options you have to access your 401(k) are dependent on your specific plan documents. Regardless of the options you have for accessing your retirement account early, taking funds from the account early allows you to miss out on perhaps the most powerful benefit to investing, compound interest. Whenever you remove funds from your account, they cease to have earnings potential. Hence, there is an inherent opportunity cost that could impact your retirement. In other words, if your account experiences 8% growth in the year following the withdrawal, you would need to replace 108% to be back where you would have been. If the 8% return continued and you waited 3 years, you would need to replace 126%. Letting this trend continue may prevent you from getting back to where your retirement funds should be.
Another reason dipping into your 401(k) should be a last resort is the issues it can potentially cause if you leave your employer. If you quit or otherwise lose your job with an outstanding loan against your 401(k), you will have until the day in which you file your next federal tax return to roll the loan to your new 401(k) plan. There is a chance, however, that your next employer’s 401(k) plan does not allow you to take out a loan against your 401(k). If this is the case, you will be required to repay the loan in full by the time you file your next federal tax return.
If your plan does not allow you to take a loan against your 401(k), your only choice might be an early withdrawal. If that is the case, taxes and penalties will make the withdrawal more expensive. In the US, an early withdrawal from a retirement account (before age 59 1/2) will subject you to a 10% penalty. This penalty applies to both Traditional and Roth 401(k)s. Funds withdrawn from Traditional 401(k)s have an added cost in taxes. Because contributions to Traditional 401(k)s are pre-tax, withdrawals are subject to ordinary income tax at your tax bracket. Hence, if your effective tax rate is 18% and you made an early withdrawal from your traditional 401(k), after taxes and penalties, you would be left with .72 cents for every dollar you receive.
Ultimately, there are many more favorable places to access money if necessary. The best recommendation, however, is to spend within your budget. Your 401(k) is designed to be used to fund your retirement, not to fund major purchases or support your lifestyle while working. That being said, life happens, and unplanned expenses may arise. If you have the cash in your savings, it should be the first place you look. If it is necessary for you to look outside of your non-retirement accounts, consider a loan from a relative or friend. If that is not an option and you are confident you will be able to recover the money within a year, looking into a 0% interest credit card could be an option.
