Many folks faced the new year with a fresh-start mindset, new goals, and a handful of resolutions. For some, 2017 is still at the top-of-mind with credit card balance carry-overs and a loan or two. For others, the new year brings ideas of travel, home renovations, or major purchases.
Regardless of the intent, oftentimes folks think they can simply borrow or withdraw from their 401(k) to pay for these things when their bank account is not liquid. After all, the money is theirs and just “sitting” untouched. So why not tap into the account – life is short, right?
While access to the funds and making a withdrawal is quite simple, the consequences can be complicated and have a longstanding impact. Let me explain:
Understanding the impact of a withdrawal
Generally, traditional 401(k) withdrawals are taxable as ordinary income. Ideally, and for this reason, one would not withdraw any funds from their 401(k) until after age 59 ½. Why? Because withdrawals are taxed as “taxable income” as if it were an earned paycheck (same as a job). The plan is to defer taxable income to the years when one would not have as much earned income.
Withdrawing funds from a 401(k) before reaching at least 59½ years old, will incur not only income tax on the withdrawn amount, but also an additional 10 percent early distribution penalty.
Exceptions to the early distribution penalty include:
- Death
- Disability
- Medical expenses - amount of unreimbursed medical expenses (>7.5% adjusted gross income; after 2012, 10% if under age 65)
- Certain distributions to qualified military reservists called to active duty
- Rollovers - in-plan Roth rollovers or eligible distributions contributed to another retirement plan or IRA within 60 days
- Separation from service - the employee separates from service during or after the year the employee reaches age 55 (age 50 for public safety employees in a governmental defined benefit plan)
Related read: Why Your 401k Plan May Not Be the End-all Be-all
Borrowing against a 401(k)
We’ve often heard folks discuss borrowing against their 401(k) account instead of taking an early distribution as a way to avoid the 10% penalty. Don’t be misled- there are significant drawbacks. Here are some of the most prevalent:
- Double taxation on the interest component. If you take a loan from your 401K, you will need to pay interest to your 401(k) plan with after-tax money. By borrowing against a 401(k), you now have to earn the money, pay taxes on the borrowed amount, and put the interest back into the plan. When you withdraw the funds again year later (at retirement age), you'll pay income tax on the withdrawal. Simply, this defeats the purpose of having a tax-deferred account.
- If you leave your employer before the 401(k) loan is repaid, any outstanding balance may be treated as a taxable distribution to you unless the loan is repaid entirely within a specific amount of time.
- Most do not realize that 401(k) money is protected from creditors and bankruptcy. If you borrow funds from the plan to pay debts, remain in financial trouble, and ultimately end up filing bankruptcy, you will have used once-protected money to pay debts, when this money would have been protected for your retirement use had it remained in the 401(k) account.
- Many ultimately contribute less to their retirement plan because a portion of new contribution must be used toward paying off the loan first.
- Not all 401(k) plans permit employees to borrow from the accounts. Check with your human resources department before you even begin to consider taking a loan against your 401(k).
As you have read, borrowing against a 401(k) has significant drawbacks. Some may want to consider such loans if they are in a financial pinch and the only option appears to be tapping into retirement money. Even with their drawbacks, a 401(k) loans are generally preferable to an outright 401K withdrawal, although neither is ideal. One should consider if a withdrawal makes the best sense for the overall financial picture.
I help folks look at the tax implications not only for today, but also years to come. It’s best to consult with a tax advisor before taking any early distributions or loans from a 401(k) account.
If you have questions, contact us at info@zinnerco.com or216.831.0733. We're happy to help and ready to start the conversation.
