Let’s face it. Everyone goes through hard times. Sometimes life can throw you curveballs. When that happens, it is easy to reach for what is easy. When you have unintended expenses come up, there are several ways that you can choose to handle them. A lot of people will look to their 401k first. But I’m here to tell you that is a bad idea. Let me explain the answer to the question, “Should I take money out of my 401k?”
Use Your Emergency Fund First
First and foremost, let me tell you that I am not heartless. I am not so removed from reality to think that there are no times when someone might need to take money out of their retirement plan. However, I do think that most people who take withdrawals from their retirement plans usually do it prematurely or because they do not have an emergency fund.
As I’ve stated before, you WILL have emergencies in life and you NEED to have the money put aside to take care of those emergencies. The money needs to be liquid (meaning that you can get a hold of it immediately). If you just don’t make enough money to allocate some money to an emergency fund, check out some side hustles that you could do to help get you there.
So when (not if) you have an emergency, take the money out of your emergency fund first. If you have an emergency fund, you won’t need to even consider taking it out of your 401k.
So should I take a 401k loan? Not if you have an emergency fund. If you have depleted your emergency fund, then maybe. But not before.
Reason #1 to Avoid Taking Money Out of a 401k Early
The first (and arguably the most) important reason you should avoid taking money out of your 401k is because if you are not 59 ½, you will be taxed and penalized.
If the account is an after tax account (traditional 401k, traditional 403b, etc) you will have to pay your tax rate PLUS a 10% penalty on the money. If you are 59 ½ or older, you will not have to pay the penalty, but you will have to pay the taxes.
You work hard for your money. And I know how difficult it can be to set money aside for your future. Don’t undo all of that hard work by taking it out early and paying penalties.
Reason #2 to Avoid Taking Money Out of a 401k Early
If you decide to take out a loan against your 401k instead of a regular withdrawal, you will have to pay yourself back with interest.
This might sound okay, but if you are having a financially difficult time do you really want to take on ANOTHER payment? It can easily be a recipe for disaster.
Interest rates on 401k loans vary from company to company but generally are 1-2% above the prime rate. The prime rate can vary from month to month, but it is currently (March 2023) 7.75%. That means that a loan would have an 8.75-9.75% interest rate! Don’t do that!
Reason #3 to Avoid Taking Money Out of a 401k Early
If you were to decide to take out a 401k loan, and you don’t pay it back by the time that you leave the company (whether it be through termination, resigning, retirement, or death) your loan will be deemed an early distribution and you will have 60 days to repay it or be charged your tax rate PLUS a 10% penalty.
So between simply taking an early withdrawal of your 401k and taking a loan out against it, taking a loan out is the better option (but still not a very good one).
Just know that you HAVE to pay back that loan before you leave the company or it will be considered an early distribution if you don’t pay it back in two months after you leave.
Reason #4 to Avoid Taking Money Out of a 401k Early
One of the biggest reasons that you should avoid taking money out of a 401k (or any retirement plan for that matter) early is because you will forfeit any growth that the account would have otherwise had during that time.
Think about it. You have $50,000 in a 401k and the market goes up by 10% over a year and you would have $55,000.
But if you would have taken that money out of the account you would have no money to grow! You would have sacrificed that growth as well as likely paid taxes and penalties (if you were not 59 ½ yet).
Your money is there to grow so you have it later. Not so that you can use it now.
Reason #5 to Avoid Taking Money Out of a 401k Early
This is the biggest reason for me.
Do not take money out of your 401k because that is not what the account was meant for.
If you have an emergency, use your emergency fund. If you exhaust your emergency fund, then you can dip into your 401k. But only as a last resort.
In our financial lives, we have different buckets to pull from when we need money.
To pay our regular bills, we use our checking account.
To save for college we can use 529 plans.
For emergencies, we should use our emergency fund.
And for retirement, we should use retirement accounts.
Don’t let these accounts spill over to each other if you can at all help it.
Final Thoughts
I hope that I wasn’t unclear 🙂
You should only take money out of your 401k if it is a true emergency and if you have exhausted all other options.
But if something happens in your life (or already has) that has caused you to dip into your retirement plan, don’t beat yourself up over it. It happens.
Just do what you can to repay yourself, build a big emergency fund, and not let it happen again.
I have been there too. I have taken money out of my retirement account early and paid the taxes and penalty. Not because I was in a desperate way, but because I was irresponsible.
I am here to help you!
You can do this!
Until next time!
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