Thinking about using your 401(k) for quick cash? Think twice before you cash out or borrow. The money in your workplace retirement plan should be your last resort for paying off various types of debt.
You can take money out of these accounts for a “hardship" situation, such as paying for tuition or medical costs.
But hardship withdrawals can come at a high cost:
- Once you receive the withdrawal, you'll owe income tax on any pretax money you withdraw, including your own contributions, your employer's contributions and your investment earnings.
- You will likely have to pay a 10% federal penalty for a premature distribution as well as a possible state penalty because you are under age 591/2.
- You may be forced to save more in the future just to catch up.
You can take money out of these accounts for a “hardship” situation…but hardship withdrawals can come at a high cost.
To borrow or not to borrow
You can borrow money from your retirement plan and pay the funds back with lower interest rates than other types of borrowing, such as a credit card. However, a loan may trigger fees, and you may be forced to pay back the entire amount you borrowed if you leave your job, voluntarily or not. You also need to find out how your employer structures these types of loans.
The high cost of hardship withdrawals
So what's the best way to have money for unexpected expenses? Build an emergency fund. You can tap into that without incurring early withdrawal penalties.
Generally, you should have enough cash to cover three to six months of living expenses in case of an emergency, like being laid off from work.
If saving that much money seems daunting, start small. Aim to build a fund of at least $500 and go from there. Be sure to build your savings back up when you take money out of the account. Don’t forget to take advantage of the power of compound interest.
What other options are there if you need cash?
- If you have a Roth IRA for five years, you can withdraw your original contributions at any age, free of federal taxes and penalties.
- For education expenses, explore scholarships or student loans. You can borrow for school but not for retirement.
- You can borrow against the value of your home with a home equity loan or home equity line of credit.