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Pros and Cons of Tapping Your 401(k) for Emergency Cash
Yes
It’s tempting, it’s mighty tempting. You or your spouse has just been laid off, and money is tight. There sits your 401(k) plan, plump from several years of good returns, even after the current market slide, waiting for you to use it. Resist the temptation, say many CERTIFIED FINANCIAL PLANNERS™. Taking money now from your retirement account to pay immediate bills is robbing your financial future.
Before dipping into your retirement account for cash, explore alternatives. First, don’t do anything hasty. You may get a new job more quickly than you think. Second, cut household expenses as much as possible. If that doesn’t bridge the gap between income and expenses, consider tapping into non-retirement financial sources such as taxable savings or money market accounts, cash-value life insurance, or taxable investments such as mutual funds or individual stocks or bonds. Weigh your options carefully before deciding, however. It might be better to borrow in some cases than to sell some investments.
After all this, the 401(k) may still look appealing. However, before tapping into it, keep these points in mind.
You have two ways to use 401(k) assets for an emergency: take money out permanently or borrow. On permanent withdrawals, you will pay regular income taxes, presuming all the contributions in the account were pre-tax. You’ll also likely pay a ten-percent early withdrawal penalty on the money if you are younger than 59 1/2.
The obvious downside to taking money out permanently is that you can never put it back and the money can never again grow tax deferred in the account to help pay for your retirement. This loss of tax-deferred growth could cost you thousands of dollars over the years. That’s why borrowing is usually the preferable option of the two if you must tap your retirement account. Not all 401(k)s or similar employer-sponsored qualified retirement plans allow loans, but the majority do. However, most employees will not be able to borrow from their employer’s 401(k) plan after they’ve been laid off. In fact, laid-off employees will likely be required to pay back within 90 to 120 days any outstanding loans incurred before the layoff.
Assuming you have access to your or your spouse’s plan, you typically can borrow up to half of the plan’s account balance, though no more than $50,000. You may be able to borrow up to 100 percent if the amount in the account is small enough. With the exception of borrowing for a home, you must pay the loan back within five years in regular payments, at reasonable (roughly market) interest rates. That’s one of the good features of borrowing from your own retirement account: you’re paying the interest payments to yourself instead of another lender.
Pros and Cons
The big risk with borrowing is that if you fall behind on your loan payments—a distinct possibility if you are laid off—you could end up paying federal, and possibly state, income tax on the portion of the loan that’s not been repaid, plus that ten-percent penalty if you’re younger than age 59 ½. This is because the Internal Revenue Service treats any un-repaid amount as an early distribution.
Even assuming you pay yourself back, you may still suffer what is known as an “opportunity cost.” That means the investments in the account could have earned more money than the interest rate you are repaying yourself with. Furthermore, you’re not really “earning” money by paying yourself back. You’re using your own dollars out of cash flow and those dollars could have been invested elsewhere. You’re also paying back the loan with after-tax dollars. When you withdraw that money years later for retirement, you’ll pay tax on it—again!
This is not to say you should never borrow from your retirement plan. Sometimes a financial emergency demands the need for prompt cash and you don’t have good alternatives. However, before using your future retirement money, carefully consider all options and be sure you use the money only for emergency needs, such as making a house payment or health insurance premiums. Don’t spend it on nonessentials such as entertainment or buying a new television set.
This article was submitted by the Financial Planning Association, the membership organization for the financial planning community. FPA members are dedicated to supporting the financial planning process in order to help people achieve their goals and dreams. Submission of this article does not imply an endorsement or recommendation of the Financial Resource Center site.
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