Before you take money from your 401(k)

Is it ever OK to raid your 401(k)?

Did you ever need money and think about taking a loan or withdrawal from your 401(k) account -- but aren't sure how to do so or if it's ever a wise move?

You've got lots of company. Representatives who take calls for retirement plans say withdrawal and loan requests and related questions consume the biggest portion of their time.

But what it all boils down to when figuring if this is a good idea depends on what you'll do with the money.

Most financial pundits say never take money from your 401(k) plan because you're reducing funds you'll need for retirement. Another good reason to avoid taking early withdrawals is that when you take money out, you'll pay more income taxes and penalties than you would otherwise. It's hard to argue against these reasons.

But if the measure of your financial health is your net worth (assets less debts), taking cash from your 401(k) plan to pay off debt has no immediate impact on that. Less money in your 401(k) is offset by less debt.

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Look at this more closely. For example, let's say the funds in your 401(k) plan have been earning a rate of return of 7 percent. But the debt you're carrying is costing you 18 percent. In that case, taking money from your 401(k) to pay down 18 percent interest debt is the same as earning 11 percent (the difference between the 18 percent interest cost on the debt and the 7 percent earnings on the account).

Here is another example: Let's say you want to buy a home, but you don't have enough cash for the down payment to get a good mortgage. Your choices include:

  • Getting a nonconforming mortgage with a higher interest rate and mortgage insurance.
  • Waiting until you save the down payment and miss out on buying that home and possibly low mortgage interest rates.
  • Withdraw or borrow the cash from your 401(k) account and get the house with a low-rate mortgage.

In this case, the last choice might be the best.

The advantage of taking a loan from your 401(k) to purchase a primary residence is that it can be paid back over 15 years or over the term of the mortgage. The loan is qualified as a "principal residence loan," and the interest paid qualifies as an itemized deduction as "qualified residence interest."

If you instead take a "hardship withdrawal" from your 401(k), which is permitted for the purchase of a primary residence, then the amounts withdrawn are taxable as income and an additional 10 percent penalty tax is also applicable. Also, hardship withdrawals cannot be paid back into the 401(k) plan.

If your 401(k) plan allows you to take a loan, and you want to do it for one of the financial situations above, then do so. Unlike hardship withdrawals, amounts borrowed through a 401(k) plan loan aren't taxable as income unless the balance goes unpaid.

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An exception to this strategy is that individuals owning a 401(k) plan account with an employer for whom they no longer work typically cannot take a loan. Instead, they can transfer their 401(k) account to an IRA and then take hardship withdrawals that are free from the 10 percent tax, if the distributions are used for things like medical expenses allowed as an itemized deduction, qualified education expenses and qualified first-time homebuyers. 

To properly report penalty-free withdrawals from an IRA, you'll need to complete IRS form 5329.

But when you take a 401(k) loan and later can't afford to repay it, the unpaid loan balance will become a taxable hardship withdrawal. Hardship withdrawals from retirement plans are typically allowed for things like uninsured medical expenses or to make mortgage payments to avoid foreclosure of their home. 

Although those are truly hardship situations, these individuals are better advised to seek other forms of financial relief, rather than striping cash from their retirement plans. One reason is that under federal law, assets held in an employer's retirement plan are excluded from the judgments for creditors during bankruptcy. Rather than spending down retirement assets, only to prolong the inevitable bankruptcy, it may be better to not touch these protected assets and get the bankruptcy process going sooner rather than later.

And since most states provide some exemption for your home, after bankruptcy you'll still own that and your 401(k) account.

Also, low-income individuals (including those who suddenly find themselves unemployed) who face unexpected and large uninsured medical expenses may also qualify for a certain form of Medicaid benefits that consider primarily income. Pulling cash from retirement accounts in this situation may be unnecessary, and it may be better to get the Medicaid application process underway. 

In both situations, your best move is to seek the counsel of a qualified attorney on the best course of action before you take a nickel from your 401(k) plan.      

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