When an emergency occurs and you need cash, that lump of money sitting in your retirement account suddenly looks very tempting.
I recently spoke with an investor who experienced an emergency and wanted to take a loan from his 401(k) until he received his insurance settlement. He was very aware that his 401(k) should be his last resort and was struggling with the decision. Of course, he also received unsolicited advice to take a hardship withdrawal. Thankfully this investor was not only thinking through the situation, but he also sought professional advice.
To start, distributions from your 401(k) will have a 10% penalty tax if you are younger than 59 ½. Distributions are also taxed as ordinary income, which would result in an additional withholding of 10% to 37% for tax purposes. Keep in mind that this is just federal tax—you may also owe state tax on a withdrawal. Secondly, even if you fall into one of the exceptions that waives the 10% early withdrawal penalty, you’ll need proof for the IRS. For example, if you are withdrawing $7,000 for medical expenses, you’ll need to have receipts for $7,000 in medical expenses; otherwise, the IRS may deem it as a premature distribution, and you will owe the penalty and perhaps more for underpayment of taxes.
Loans are different in that you can pay back the loan with interest to your 401(k). However, not all plans offer loans. The provision for loans is in the plan documents your employer designed, so only some plans allow loans. A few…
Read the full article here