If you participate in a 401(k) plan, you probably know that it’s possible to take money from your account before retirement. Aside from retirement, death, disability, or divorce, there are essentially two ways you can do this: 1) a hardship withdrawal or 2) a loan.
Removing Money from Your 401(k) before Retirement
The Internal Revenue Service (IRS) allows you to take a qualified hardship withdrawal if the funds are used to:
- Pay qualified higher education costs for yourself, your spouse, or any of your dependents.
- Purchase your principal place of residence.
- Pay qualified uninsured medical costs incurred by you, your spouse, or a dependent.
- Make payments to avoid foreclosure on your principal place of residence.
Keep in mind, however, that a qualified hardship withdrawal does not avoid the 10% Federal income tax penalty for withdrawals (except for qualified uninsured medical costs as explained in the third point above) made before age 59½, and income taxes will still be due in all of the above circumstances.
What about 401(k) Plan Loans?
Most 401(k) plans also allow you to borrow a portion of your account balance. By law, the plan itself cannot set loan minimums that exceed $1,000. In addition, loans cannot exceed the lesser of 1) 50% of your vested account balance or $10,000, whichever is greater; or 2) $50,000, less any outstanding loan balance from the past 12 months.
Generally, loans must be repaid-with interest within a set period of time (typically, five years). Interest rates are generally comparable to commercial loans. As long as the terms of the loan are met, there is no 10% Federal income tax penalty for early withdrawal or income taxes due (naturally, an actual withdrawal is an income taxable event). Bear in mind that tapping into your 401(k) early is generally considered a last resort. Accessing funds before retirement may affect your long-term goals and future financial security.
READ MORE: 401(k) Loans - Pros and Cons ... Coming Soon
You might be considering taking out a loan from your 401k. But before you do, you should know the rules and weigh the risks against the benefits. Because not knowing the rules and understanding the risks might hurt you and your retirement in the long term.