4 good reasons not to raid the 401(k)
If you’re thinking of withdrawing or borrowing money from a 401(k) to pay for some expenses, think four or five times first. There are some very good reasons not to do either.
Let’s tackle withdrawals first:
1. As the IRS web site states, “Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies.” This means that you’re going to have to pay federal, state, and local taxes on your distribution, PLUS an additional 10% penalty. If your normal taxes add up to 35%, you’ll pay 45% of the money in taxes. So if you were to withdraw $5000, you’d wind up with $2750. Maybe you only need $2750, so that doesn’t seem like a bad deal, but would you pay 81% annual interest on a credit card? That’s essentially what you’d be doing: paying $2250 of your hard-earned money to use $2750 of it.
2. You’ll lose out on the money you’ll need in retirement. Take the hypothetical $5000; not only will you not have that, but you’ll miss out on the future earnings of that money. If you had left the $5000 in there and never added another penny, in 30 years at 7% interest it would have grown to $38,061. It’s probably a lot easier to find the $2750 you need now than it is to find $38,061 later.
What about borrowing against a 401(k)?
3. You’re going to put the money back, so it’s not such a big deal, right? Wrong. The money you originally put into your 401(k) is pre-tax money. The money you’ll have to pay back is money that you’re taxed on, plus interest. Then, when you eventually do take the money out when you retire, you’ll pay taxes on it again. This means it costs a lot more than it first appears to borrow money from a 401(k).
4. If you lose your job or quit before the loan period is up, the entire amount that you borrowed quickly comes due. If you can’t pay it back in the (very short!) time period allowed, it counts as an early distribution, and you’re back to paying taxes & the penalty on it.
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