Don't use your 401(k) as a piggy bank

During the housing boom earlier this century, when folks were strapped for cash they often borrowed against their homes. But since the financial crisis of 2008, it's a lot harder to tap into the value of your home. Now many people are turning to another source of quick cash -- their own 401(k) fund.

According to a report from Bloomberg Businessweek, in 2011 Americans withdrew $57 billion from their retirement accounts before they reached the age when penalties no longer apply -- typically age 59 ½. The IRS collected $5.7 billion in early withdrawal penalties that year.

According to data from Fidelity, the largest 401(k) plan servicer, workers aged 20 to 39 have the highest withdrawal rates, with 41 percent cashing out their retirement plan accounts when they leave their job.

Younger workers who do this think that their small balance isn't worth the trouble to roll over. The problem is that cashing out these small 401(k) plan account balances can have a significant impact on future savings. Workers are likely to change jobs five to seven times before they settle into a long-term position. If they cash out their 401(k) every two years, they could find themselves with nothing saved for retirement well into their 30's.

Many people are also taking cash from their 401(k) plan when they have no plans to leave their current job. They do this by requesting a hardship withdrawal.

Hardship withdrawals allow employees in tough financial situations to take a distribution from their retirement account while they're still working. But doing so comes at a cost. Hardship withdrawals are reported as taxable income and an additional ten percent penalty also applies if you are under age 59½. Most employers' 401(k) plans bar employees from making contributions for six months after taking a hardship withdrawal.

Also, many employers require you to provide a written explanation of the reason for requesting a hardship withdrawal and why the need cannot be satisfied from other resources. Revealing these private details to your employer can be awkward.

According to IRS rules, hardship withdrawals are only permitted for these reasons:

  • Qualified medical expenses that exceed 7.5 percent of adjusted gross income
  • Purchase of a primary residence
  • Payment of qualified tuition expenses
  • Funeral or burial expenses
  • Home repair expenses due to casualty losses
  • To prevent eviction or foreclosure of a mortgage on a primary residence

The money taken as a hardship withdrawal cannot be repaid to your 401(k) account. So, like cashing out the money when you change jobs, these withdrawals permanently reduce the balance of your retirement savings.

If you plan to stay at your job and can't get a loan through another source, a far better option than a hardship withdrawal is to take a loan from your 401(k) plan.

And, if you're changing jobs, don't fall prey to temptation and cash out your 401(k). You'll be better off in the long run if you roll it over into an individual retirement account or your new employer's plan.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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