Millions of retirees rely on an employer-sponsored 401(k) account to save for retirement. Assuming you work for the majority of your life, your 401(k) can amass quite a large sum of money, creating a nest egg you can rely on for your retirement years.
While traditional 401(k)s are designed for retirement saving, there are ways you can access your money early, should you find yourself in a precarious financial situation before you retire. However, if you cash out your 401(k) too soon, you should be prepared to pay additional fees on top of taxes. For this reason, you should carefully consider whether dipping into your 401(k) is a good idea.
Understanding your 401(k)
With a 401(k), you are able to take a portion of your income out of your check and put it into a savings account before it is taxed. Your employer will typically also contribute money to this account as a part of your employee benefits package. Once the money is in your account, you can control how it is being invested so that it can earn more money over time.
Most employer-sponsored 401(k) accounts are considered “traditional,” meaning they come with rules and restrictions that limit how you access the funds in the account. Most importantly, you won’t be able to access the funds in your 401(k) without penalty until you are 59 ½ years old. If you dip in early, you could owe the government up to 10 percent in fees, on top of the normal tax owed.
When should you tap into your 401(k)?
Because of the restrictions on using 401(k) funds before you reach retirement age, most people try to avoid relying on the account until it can be accessed without penalty. Unfortunately, some situations might make it tempting to dip in early.
According to Samuel Rad, a Certified Financial Planner in Los Angeles, you’ll typically want to avoid using your 401(k) funds for any reason until you reach retirement, after which you’ll be able to take fund distributions and pay the taxes on them as intended. This saves you the most money, since you won’t incur any unnecessary taxes or fees, leaving more for use in retirement.
Under some plans, you may be eligible for a hardship distribution, which waives the additional 10 percent tax if your financial situation meets certain criteria. If you qualify for this distribution and absolutely need the money right away, using your 401(k) funds may be a good choice.
You may also be able to request a loan from your 401(k). In doing so, you’ll be borrowing money from yourself and will need to make payments, including interest, back to the 401(k) over time. However, this interest is deposited into your account as an investment, adding to your total balance.
This can be a better option than taking money out and incurring a fee. However, if you will struggle to pay back the loan and interest, you should avoid it, if possible. Additionally, doing this may prevent you from adding money into your 401(k) during the loan repayment period, so you could potentially miss out on a few years’ worth of contributions, as well as the compounding you could have earned during the loan period.
If you are trying to use your 401(k) money for a “want” instead of a “need,” or you have other financing vehicles to choose from, such as unrestricted savings accounts, other investments or liquid assets, those would probably be better options to use.
Many Americans make big mistakes with their retirement savings because they are misinformed or are not sure where to turn to for financial advice. By working with a financial advisor in Los Angeles, you can gain a better understanding of your finances as a whole and learn what you need to do to build and protect your nest egg as you near retirement.