Do you use an employer-sponsored 401(k) to save for retirement? You’re not alone. It’s a powerful savings tool, primarily because it offers tax-deferred growth and the potential for employer matching distributions. Those two components can help you accumulate retirement assets.
However, you also may be able to tap into your 401(k) before retirement. Many plans allow you take funds early either through loans or distributions. Although it may be tempting to dip into your 401(k) in the event of an emergency, you may want to resist doing so.
Recent studies show that 401(k) distributions may be creating a crisis for retirees. A study from Deloitte estimates that there will be more than $7 billion in 401(k) loan defaults in 2018 alone. The study also found that the loan distributions and the loss of future investment growth could create a $2.5 trillion shortfall for retirees.1
Loans are just one piece of the issue. Many people also choose to cash out their 401(k) after a job changer rather than rolling the balance into an IRA. This decision eliminates future tax-deferred growth and creates current penalties and tax liabilities. More than 40 percent of job changers cash out their plan, and in 2017 the total value of cash-out distributions reached nearly $68 billion.2
Still tempted to tap into your 401(k)? Below are a few of the ways in which a loan or distribution could hurt your retirement:
Loan Repayments and Interest
Most 401(k) plans have loan provisions that allow you to take money out of the plan for any reason, even if you haven’t reached retirement age. Since the distribution is a loan, you don’t pay taxes or penalties.
The distribution creates a debt inside your 401(k) plan. You repay the debt through your 401(k) contributions. That means a portion of each of your contributions goes toward the loan balance. Since some of your contribution is used to repay the loan, that’s less money that’s being used to grow your retirement assets.
Your loan will also likely have interest. The interest rates on 401(k) loans are usually low, but there is interest. You’ll end up paying more than you borrowed.
Taxes and Penalties
Your 401(k) loan is initially tax- and penalty-free. However, that could change if you default on the loan. That often happens when someone leaves a job and 401(k) plan before they repay their loan. If the balance goes unpaid, the loan is considered in default. It then becomes a taxable distribution. If you’re under age 59 ½, you’ll also face a 10 percent penalty.
You could also face taxes and penalties if you choose to cash out an old plan balance after leaving an employer. The distribution is fully taxable as income and you also have to pay the 10 percent penalty if you’re under age 59 ½. Those costs can substantially reduce your distribution amount. You can avoid taxes and penalties by rolling an old balance into an IRA.
The biggest cost associated with 401(k) loans and distributions may be the one that slips under the radar. When you take money out of your 401(k), you no longer get future growth on those assets. Remember, your 401(k) funds compound tax-deferred over time. A distribution reduces the amount that’s available to grow. That could substantially reduce your future retirement balance.
Ready to implement a strategy to protect your 401(k) plan? Let’s talk about it. Contact us today at Carstens Financial Group. We can help you analyze your needs and develop a plan. Let’s connect soon and start the conversation.
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18184 - 2018/10/22
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