Thinking of tapping into your 401(k) to help pay for large expenses, such as college tuition or medical bills? Generally speaking, it’s a good idea to look for other sources of cash before pulling funds out of your 401(k). Your 401(k) plan is meant for retirement. If you pull money out before you retire, you may lose out on tax deferral and investment growth.
You also may face taxes and an early withdrawal penalty. Your 401(k) account is tax-deferred, which means you don’t pay taxes on your growth until you make a withdrawal. It’s tax-deferred because it is designed for retirement savings. If you take money out before retirement age—designated as age 59½ in 401(k) plans—you could pay a 10 percent penalty on top of income taxes.
However, if you need the money and have no other options available, you may have no choice but to take money from your 401(k) plan. Fortunately, there are a couple of ways to take out money without facing the early withdrawal penalty. One is through a loan, and the other is through a hardship withdrawal.
Most 401(k) plans have loan provisions that allow you to take money from the plan without paying taxes or the early withdrawal penalty. When you take a 401(k) loan, you’re essentially borrowing money from yourself. The money is removed from your plan and paid to you, with no taxes or penalties due.
Loan rules vary by plan, but usually you must make periodic repayments to the plan and pay off the balance within a specified period, such as five years. If you fail to make full repayment, the loan could be converted into a withdrawal, which would trigger penalties and taxes.
Your plan may also have limits on how much you can borrow. For example, your plan may cap loans at $50,000 or at 50 percent of your balance.
The biggest cost of a 401(k) loan, however, may be the loss of investment growth. After the funds are disbursed as a loan, they’re no longer invested in your account. That means those funds are no longer being used to grow your balance. That loss of growth could throw you off track from reaching your retirement goals.
Another way to take money from your 401(k) plan without paying taxes or penalties is to apply for a hardship withdrawal. The IRS allows you to pull money from your 401(k) account without paying taxes or penalties for certain extenuating circumstances.
For example, you may qualify for a hardship withdrawal if you plan to use the funds for any of the following:
You can also take annual income through something called regular periodic distributions, also known as 72(t) withdrawals. Under 72(t), you agree to take a periodic distribution for a set number of years or until age 59½. If you deviate from the withdrawal plan, you may face penalties.
Also, keep in mind each of these situations has its own set of rules. For instance, you may need to qualify as being totally disabled to receive a hardship withdrawal. Or your medical bills may need to meet a certain threshold to be considered a hardship.
You may be best served by finding an alternative solution rather than pulling money from your 401(k). Contact us at Carstens Financial Group. We can discuss your needs and develop a plan to help you meet your goals. We look forward to serving you.
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