If you’ve fallen on hard times and need extra money, cashing out your 401k account may seem like an attractive idea. It’s neither a wise nor an easy thing to do, especially if you are still employed by the company managing your 401k plan. Keep in mind that you may not be entitled to all of the money in the account if your employer has contributed matching funds.
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The easiest way to take money out of your 401k with your current employer is through a loan. Most plans have loan allowances. Usually you can borrow up to half of your vested amount to a maximum of $50,000, and you will have five years to pay back the loan. When you take a loan, you are not subjected to penalties, and the interest rates are typically competitive. You pay back the principal and interest to yourself. Although it’s better to pay yourself interest than a bank, you limit your retirement nest egg’s ability to grow tax-free when you take a loan from your 401k.
Your loan becomes due immediately if you lose your job or leave to work for another company. If you fail to pay it back it back, the outstanding balance is treated like an early withdrawal. Early withdrawals are subjected to a 10 percent penalty plus all of the taxes due. An early withdrawal is treated as income for the tax year in which you received it.
Many plans allow for hardship withdrawals; however, you are still liable to pay the early withdrawal penalty and any taxes. Acceptable hardship withdrawal reasons may include medical expenses, college tuition or funeral expenses for a family member. You may also qualify for a hardship withdrawal to pay for a down payment on a principal residence or to avoid eviction or foreclosure. In many cases, you will have to prove you have no other resources to cover the hardship costs.
In addition to losing a sizable chunk of your savings to cover the costs of the penalties and taxes, you jeopardize your retirement security when you take a loan or withdrawal from your 401k. You should never use your retirement savings for big-ticket luxuries or vacations. Use an online cash out calculator to determine the exact costs for tapping your 401k.
Search for other loan types before using your retirement money. It’s wiser to find student loans to cover the cost of your child’s tuition than to pull money out of your 401k, especially as you get closer to retirement age. If borrowing money from your 401k is your last resort, take only the amount you need. Check with your company’s human resource department for the necessary paperwork and procedures.