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Pros and cons of taking money out of a 401(K) for cash-strapped households

Withdrawals come with steep penalties
Posted at 5:34 AM, May 19, 2022

BALTIMORE — Inflation is making it more difficult to manage household budgets as everything seems to be going up except for people's bank accounts.

Families needing more money to make ends meet might look towards their savings for some extra cash to pay their bills.

Some people might think about taking money out of their 401(K) plan. The conventional wisdom is not to touch your savings but there are some situations in which it might be beneficial to do so.

Gas, food, and energy prices are soaring. Interest rates on mortgages and credit cards are rising. With so much uncertainty about the economy, financial advisers say it's a time to prepare for the worst.

Financial business consulting firm Brokers International CEO Mark Williams said “if you were to lose a job today, and national average is about 5 to 6 months to find a new job, so if you are presented in that situation, having a safety net of four, or five, or six months worth of earnings can really be beneficial for most people.”

Williams has three basic tips for facing times of economic uncertainty:

lower your debt, decrease your spending, and increase your savings.

Without an extra source of income, accomplishing these goals could cause some to dip into their 401(K) plans.

“I’m gonna request that it be your last option because that’s your retirement. I hate for people to take part of their retirement but it is an option and it could be a very good option in several situations,” Williams said.

It could be helpful to those with high credit card debt.

“That high debt could be crippling for a lot of people so if you have some funds in your 401(K) yes you could use that as one example,” Williams said.

Anyone considering that route should be sure to check the rules of their plan first.

“Find out if, number one your plan allows you to take a loan. With withdrawals usually they do there’s also something called the Hardship Withdrawal, so if you really are in a bad situation there are less penalties and and it’s a little bit easier to take a hardship withdraw,” Williams said.

Early withdrawals that don't meet the hardship criteria, and taken before retirement age, come with steep penalties and higher taxes which decrease how much of your own money ends up back in your pocket.

“Taking money from your 401(K) because the government has provided us this tax deferral often times comes with a penalty. And, you’re reducing your 401(K) amount. So, taking a loan often times is more beneficial but there’s caution with that as well. You have to pay to back within five years and of course you have to have the means to pay it back,” Williams said.

Some might believe they have no choice when facing a stack of bills to pay but Williams suggested a few other options for cash strapped consumers.

“Take a look at some of your discretionary spending and see if you can reduce that to help pay off debt. Maybe it’s a side hustle or a hobby that you can turn into some extra cash before you dip into your 401(K), but yes there are some very good reasons to take from it. You can also borrow from your 401(K) and there’s no requirements, right, you don’t have to apply for the loan because it’s your own money so there are some benefits. I would just ask you to proceed with caution,” Williams said.

The penalties for withdrawing money from a 401(K) are steep.

For those who take money out before age 59-1/2, the IRS will take 20% off the top to cover the taxes owed, plus it will charge a 10% penalty.

It’s a loss of at least 30% of whatever amount is taken out.

For example, on a $10,000 withdrawal, a person would only pocket $7,000.

As Williams said, taking a loan from a 401(K) plan would be the better way to go for those who absolutely need the money and have no other options.