When you’re under financial duress, it may be tempting to look to your 401(k) balance as a source of relief. Your employer’s plan may have provisions that allow you to withdraw money for certain “hardships” such as major medical expenses.
Before you tap your 401(k), however, consider the immediate and long-term costs:
- The amount that you withdraw is added to your taxable income for the current year. The 401(k) funds you withdraw will be taxed at the highest incremental rate you pay, so it’s important to have your employer withhold enough so that you don’t get a nasty surprise at tax time.
. - The IRS tacks an additional 10% penalty on to most withdrawals. This is calculated after you have taken all income deductions, so you forfeit 10 cents for every dollar that you withdraw. (Under some circumstances, such as “total and permanent” disability, the 10% penalty is waived)
. - At a time when government-sponsored retirement programs such as social security are experiencing fiscal challenges, you will be diminishing your potential retirement savings.
Much is made of our ability to make “pre-tax” contributions to 401(k) plans. Contributions to your 401(k) are sheltered from current taxes. You aren’t required to pay tax on 401(k) contributions or earnings until you begin withdrawing the money after age 59 1/2. At that time, you may be in a lower income tax bracket.
The greatest benefit of a 401(k) plan, however, may be the tax-deferred gains that it allows you to accumulate over a long period of time. A $10,000 investment that compounds a 6% return for 20 years will return $32,071 at the end of the period. But a 4% return on the same investment (which might reflect your results if you had to pay taxes each year on your earnings) would only return $21,911. Investing through a 401(k) enables you to avoid yearly taxation, and the difference this makes can be tremendous!
Most experts advise 401(k) plan participants to look to all other options before considering a plan withdrawal prior to retirement. For instance, before initiating a hardship withdrawal, ask your employer if the plan has a loan feature. IRS rules allow loans of up to 1/2 the value of 401(k) accounts. If you can manage it, that’s a far better option than a straight withdrawal.
*This article is intended for informational purposes only and should not be construed at investment advice. Please consult an accountant or other licensed financial professional before making any financial or investment decisions.
No related posts.
Related posts brought to you by Yet Another Related Posts Plugin.