Fear of the 401(k): What if I Need To Get My Money Out?

"Attack of the Piggy Banks." Photo by Low Jianwei. From the Flickr Creative Commons.

One aspect of organizing your retirement saving strategy we have not discussed yet is how you can access your money in an emergency, particularly if that money is locked up in a specialized account like a 401(k).  Some people adopt a fierce “live for today” mindset and feel that life is too short to deprive yourself of anything at any moment.  After all, you could be hit by a bus or get diagnosed with a terminal illness.  Do you want your last moments on earth spent denying yourself small luxuries while your unnecessary retirement account grows?

The good news is that you don’t really have to make the choice this black and white.  There are ways to access your retirement savings if you really need them.

How do you get your money out?  There are generally two methods: loans and distributions.

First, you should check the specifics of your particular retirement plan.  Each plan can specify the terms and conditions for accessing your money.  Since the goal of most retirement plans is to get people comfortable with saving for retirement, it would be unusual (but certainly not impossible) for a plan to specify that you could never get your money out before retirement age.  A plan could also specify that no loans are allowed, only outright distributions, for example.

I have to confess that before writing this post, I never checked what the conditions were for accessing money from my 401(k) account.  Fortunately, my plan is relatively generous in its loan and distribution terms.  In the future, before contributing a large sum of money to a 401(k) or other retirement savings account, I would check these terms first.

Loans

If your plan allows loans against your 401(k) savings, they are generally relatively limited in scope.  It seems common to require a minimum loan of $1,000 and a maximum loan of the lesser of your account balance or $50,000.  The plan specifies the rate of interest on the loan and the minimum and maximum loan term.   For my 401(k) account, there are far more generous terms if you are taking out the loan to purchase a home (up to 30 years repayment) than for other purposes (up to 5 years repayment).  The plan will typically charge a small administrative fee for taking out the loan.  When you pay back the loan, both the principal and interest amounts go back to you in your retirement account.  Many people so love the fact that they pay interest to themselves rather than to a bank that they prefer to take loans against their 401(k) than utilize other methods.

What are the downsides to 401(k) loans?  The biggest one has to be that if you lose your job (whether due to your resignation, a layoff or termination), the entire balance of the loan usually comes due at once.  So you might have to come up with a large amount of cash suddenly.  In the uncertainty of today’s employment environment, this is not a small risk.  If you can’t come up with the money in time, the plan will typically convert your loan to a distribution.  The plan would then report to the IRS that you took an early distribution and you could be subject to taxes and penalties, described below.

The other downside of a 401(k) loan is that by taking money out of your plan your money is not earning interest and growing while you have the loan out.  You may also be prohibited from contributing to the plan for a certain period of time after taking out the loan as well.  So, you are missing out on an opportunity to grow your money.

As an example, suppose you were considering purchasing a new car for $30,000.  You could either take out a loan from a bank or a 5-year loan against your 401(k).  What would your choices look like?


Car Loan from a Bank 401(k) Loan
Loan Amount: $30,000 $30,000
Loan Term: 5 years 5 years
Interest rate: ~3.99% fixed (based on current bankrate.com auto loan rates) 4.25% variable (we have a choice of different rates from our different 401(k) plans. Some are as low as 3.25%. Note that these rates could possibly increase over time and fluctuate based on the prime rate. For simplicity, we will calculate 4.25% fixed
Administrative fees: $50 $165
Total interest paid (based on this bankrate calculator): $3,141.62 $3,353.20
Monthly payment: $552.36 $555.89



In this particular example, there are lower interest rates and fees available from banks than the 401(k) plan but your situation could be different and the 401(k) loan rate could be more attractive.  In this example, it doesn’t make a whole lot of sense to go the 401(k) route.

How about the loss of investment principal?  Let’s look at an example.  Suppose you had $45,000 saved in your retirement account and you took out a $30,000 loan for 5 years.  We will assume that you stop contributing to your 401(k) at all during that 5-year time period and that the only contributions you make are your loan payments.  What would happen to your retirement account balance?  Let’s assume that your 401(k) is growing at a rate of 4% per year.


If you take out the $30,000 loan: If you don’t take out the $30,000 loan:
Initial Balance: $45,000 $45,000
Loan: $30,000 $0
Remaining balance: $15,000 $45,000
Growth of remaining balance for 5 years at 4% annually: $55,038.05 (with monthly loan payments of $555.89, (using this calculator): $54,749.38 (but if you are able to contribute $100/month over the 5 years, balance rises to $61,367.28)



These calculations show somewhat confusingly that if you don’t take the loan against your 401(k) and you instead take the loan from the bank, but in order to afford the bank payments you stop contributing to your 401(k), you end up doing less well after 5 years!  However, if you can afford to both take the bank loan and still contribute to your 401(k), then you end up doing far better without the loan!  The better your 401(k) investments do, however, the less attractive the 401(k) loan looks.

So, as with most financial decisions, whether a 401(k) loan makes sense for you depends on a lot of factors, including the perceived stability of your job, the performance of your 401(k) assets and loan rates available from your 401(k) plan and private banks.

In any event, it is nice to know that you potentially have a loan option available to you from your 401(k), particularly if you have a poor credit rating and might have trouble qualifying for a private bank loan.

Distributions

Most plans will also allow you to take money from your retirement plan outright if you request it.  You can drain the entire account balance if you really want to.  In general, any time you take a distribution from your 401(k), you need to pay taxes on the money as well as a 10% penalty if you are not of retirement age.  This can end up eating up a lot of your savings and most financial planners do not recommend that you take a distribution unless you have no other options.  401(k) plans themselves also discourage distributions.  In my 401(k) plan, for example, the plan requires that you first exhaust all of your 401(k) loan options before you take a distribution.

If there is a compelling reason for your distribution, such as you are suddenly considered disabled, or for certain types of active duty military service, the IRS will cut you a break and not impose the 10% penalty for withdrawal but you will still owe the regular taxes.

There are also certain situations, such as when you change employers, that you can roll money from one retirement plan into another retirement plan, without owing taxes or penalties.

What impact do taxes and penalties have on your 401(k) withdrawal?  We will do a quick example below, assuming a person earns $60,000 per year and takes a $30,000 401(k) distribution in a given year.


Without distribution With distribution
Salary: $60,000 $60,000
401(k) distribution: $0 $30,000
Total income: $60,000 $90,000
Estimated taxes for married filing jointly based on 2010 IRS Tax Table
(assumes no deductions, credits, etc.):
$8,166 $14,856
10% Early withdrawal penalty: $0 $3,000
Total IRS Bill: $8,166 $17,856



So, of the $30,000 you withdrew from your 401(k), in the end, you get to keep about $20,000 or so (less a little bit more for state taxes) after taxes and penalties.

Losing about 1/3 of your savings to taxes and penalties is not thrilling to be sure but there could be situations where the tradeoff is worth it. While certainly you could have opted not to participate in the 401(k) at all and just put money in a savings account and took the money out whenever you wanted to, you would also have missed out on the tax break for the years you contributed to the 401(k).

As with all money questions, there isn’t one simple answer that works for everyone.  If you are contemplating any complex retirement decisions, it is time to sit down and crunch the numbers yourself or find a financial professional to do it for you.

Ruly Challenge

If you already have a retirement savings account, take a moment to read the plan documents (generally available on the website for your plan) to find out what your plan’s loan and distribution terms are.

Does the complexity of accessing your money in an emergency discourage you from saving for retirement?  Please share in the comments.