Is taking money from my 401(k) a good idea?
Financial stress is running pretty high right now. Perhaps your job has been impacted. Maybe you’re seeing unexpected health expenses. The kids are home instead of at school. There’s a lot to balance right now, and our financial coaches are here to help you.
One question we’ve seen come up more frequently is whether it’s a good idea to withdraw from your 401(k). Thanks to the CARES Act stimulus package passed in March 2020, if you’ve been affected by the coronavirus pandemic, you can pull from your retirement account through the end of 2020 without the usual early withdrawal penalty of 10% if you’re under age 59½.
You still have to pay taxes on the money you withdraw since it is treated as income, but you can spread those tax payments out over three years.
The other way to get money from your 401(k) plan is through a loan . The amount you can borrow is subject to your employer’s plan changes.
And while it may seem enticing, here are five questions to ask yourself before making this big decision to withdraw or take out a loan from your retirement plan. If you say no to any of these questions, you may want to explore other options that can save you from more financial stress in the future.
- Do you have a plan to pay back the taxes?
For withdrawals from your 401(k), the 10% penalty is waived, but the taxes that will be due are still incurred. There isn’t a separate 401(k) withdrawal tax. Any money you withdraw from your 401(k) is considered income and will be taxed as such, alongside other sources of taxable income you may receive. As with any taxable income, the rate you pay depends on the amount of total taxable income you receive that year. At the very least, you’ll pay federal income tax on the amount you withdraw. Even if you can pay it back over three years, you want to be sure you plan appropriately to pay this so that you’re not adding additional stress with potential tax debt. For example withdrawing the full $100,000 allowed would mean about $20,000 in taxes for someone with a marginal tax rate of 20% (a reasonable assumption for estimating). Spread out over 3 years that’s over $6,000 more in taxes every year.
- Are you taking this out to meet necessary expenses?
This change in the rules for withdrawal is meant to help you if your circumstances have materially changed to the point that you are not able to pay for necessary expenses including food, housing costs like your mortgage or rent, utilities, transportation and health. If you are struggling to meet these bills, then it might make sense to look at your 401(k) as a temporary source of funds, however, if you’re looking at this as an opportunity to access cash quickly for a non-essential purchase, the costs of potentially delaying your retirement may not outweigh the benefit of the short-term fix.
- Do you have a plan to pay yourself back?
As your 401(k) is designed to help you retire in the long-term, withdrawing from it earlier than expected means you may have to work more years or put even more towards saving to make up the difference. If withdrawing right now is a short-term fix, do you have a plan in place to make more income or save more money to replace the money you are taking out now?
- Are you on a monthly budget?
Many coaching clients we’ve seen are taking out money in the form of withdrawals or loans without truly understanding how much they need to take out. In order to minimize the long term impact (and your taxes) it’s important to only take out what you need. The best way to do this is to have a good understanding of your monthly budget to determine if you need to take any money out of your 401(k) in the first place, and if so, exactly how much, instead of a random, round number.
For example, a client recently asked if she should take out of her 401(k) after being furloughed. We asked how much she was planning to withdraw and she said, “I don’t know. Maybe $10,000.” Instead, we worked with her to understand what her true monthly expenses would look like for the next three months while she expected a lower income. It turned out her true expenses were closer to $8,000 for the next three months, including new health expenses she expected to incur. While she did end up taking a withdrawal, she was able to withdraw less, pay less in taxes and keep her spending in mind for the near future and not create additional debt.
- Are you doing this as a last resort?
We understand that this may be a stressful time for you, and that’s totally reasonable to want to solve the stress as soon as possible. However, we hope you’ll keep in mind that building a financial future is a marathon and not a sprint and why you started contributing into your 401(k) in the first place. Before dipping into your retirement funds, consider other alternatives to make up the income you need:
- Can you build an emergency fund?
- Can you cut or delay some short-term expenses?
- Can you negotiate any of your bills?
- Can you find other streams of income?
As always, the BrightDime coaching team is here, so you don’t have to do this alone. We can walk you through if withdrawing or taking a loan makes sense in your situation. Head to your dashboard to chat with a coach now.
This article was published in September 2020. The details are specific to the months from March to December of 2020.