When you have a financial emergency or growing credit card debt, it may be tempting to tap into your 401 k account. But dipping into your retirement account before you reach age 65 may come with heavy financial penalties.
Today, more Americans are tapping into their . Workers are saving more in retirement accounts and have begun to view them as financial lifelines when emergencies arise. This strategy is dangerous and could cost you thousands.
Most financial experts say using retirement savings to pay off debt or deal with an emergency is a bad idea.
This article will discuss 401k early withdrawals, how they can impact your finances, and how to survive a financial emergency or mounting credit card debt.
What is a financial emergency?
First, let鈥檚 examine the differences between a financial emergency and a non-emergency.听
A financial emergency is a sudden, unplanned event or expense that threatens your financial security. Often, this involves your or a loved one鈥檚 health, housing, transportation or basic survival. A financial emergency usually requires money that is not a normal part of your budget.听
A non-emergency involves events or circumstances that you can plan for in advance. So, a vacation, school tuition, routine car or house maintenance, impulse purchases, late fees or overdue bills are not considered financial emergencies.听
Emergency funds help to cover the unexpected expenses that come along with a financial emergency. These special savings accounts provide financial security, prevent debt and enable peace of mind.
糖心原创vlog offers advice on how to build an emergency fund. We outline the importance of saving, cutting back on non-essential expenses, how to fund your emergency account and more. Our member counselors also have experience helping people build emergency funds while paying off debt. We鈥檙e happy to help you!
Is it a good idea to use your 401k account in a financial emergency?
Experts urge caution before dipping into your 401k. Withdrawing funds early can incur taxes and penalties, slow your account growth and may impact how much Medicare will cost.
鈥淏efore tapping into your 401k for any reason, it鈥檚 important to consider the implications and how withdrawing funds could impact your overall financial situation,鈥� cautioned Tara Alderete, senior director of Enterprise Learning for Money Management International (MMI), an 糖心原创vlog member.听
Amanda Reid-Raper, credit counselor for Consumer Credit of Des Moines, agrees. 鈥淎 401k can feel like a quick fix because it is money you have saved, but we usually recommend looking at other options first. It can fix the immediate problem but create a bigger one later.鈥澨�
鈥淵our 401k should be treated as a last resort,鈥� says Lara Ceccarelli, Client Success Coordinator for American Financial Solutions, also an 糖心原创vlog member.听
Short-term consequences of dipping into your 401k early
An early withdrawal from your 401k has both short- and long-term costs, especially before you reach age 59陆.
鈥淚n the short-term, the withdrawn amount will be subject to both income tax and to a 401k early withdrawal penalty, except in very limited circumstances,鈥� said Ceccarelli. 鈥淭his means that a significant portion of the amount withdrawn will be lost.鈥�
For example, withdrawing $20,000 from your retirement account before age 59陆 triggers immediate federal tax withholding. With overall taxes and penalties, the $20,000 you withdraw today can be dramatically reduced to $14,400 or less, depending upon your specific situation.听听听
If you鈥檙e 59陆 years of age or older, the 10% penalty is not assessed, but the 20% withdrawal penalty remains. You also have to pay state income tax on the amount withdrawn. There are a few caveats that may allow you to . Details can be found on the IRS website.
Long-term consequences of utilizing your 401k for a financial emergency or to pay off debt
鈥淵ou may have taxes, penalties or loan repayment issues, and the money you withdraw is no longer growing for retirement,鈥� said Reid-Raper. 鈥淚f the budget issue that caused the debt is not addressed, the credit cards could build up again, leaving you with both new debt and less retirement savings.鈥�
This equates to an opportunity cost, Ceccarelli explains. 鈥淢oney that is placed in a 401k account compounds as your investments grow over time. When you withdraw those funds, you lose both the amount you took out and the future gains those dollars would have generated over time.鈥�
Other considerations
If you are close to retirement age, a large withdrawal from your 401k may increase your adjusted gross income so much that it triggers surcharges on Medicare costs. Surcharges are based on income two years before Medicare begins.
Some people ask about 401K hardship withdrawals. Some retirement plans allow for hardship withdrawals, but they are still penalized and are often not easy to do.
401k loans are also an option, but interest must be paid on the loan (though often less than normal loans). A loan from your retirement account must typically be paid back within five years or less. Additionally, if you leave your employer before you pay the loan back, the balance will be due in 90 days, or you must take it as a withdrawal and incur the tax-related early withdrawal penalty.
What to do when a financial emergency hits
鈥淧ause and weigh all options,鈥� Reid-Raper advises. While this can be hard to do because an emergency requires quick action, thinking through your options can help prevent costly mistakes.听
Before making a decision, do the following:
- Assess your situation. Take stock of your income, expenses and available resources and adjust your budget to eliminate unnecessary expenses or find ways to increase your income until things change.
- Speak to your employer to see if you qualify for employee assistance or hardship programs.
- 糖心原创vlog your creditors and utility providers to explain the situation and discuss your options.
- Explore non-profit resources. Many communities have local organizations that can help with true emergencies, even if you don鈥檛 qualify for government assistance. This typically includes housing costs, groceries, utilities and sometimes even more niche expenses, such as emergency vet bills. , is a good place to start.
- Research financing options, such as personal loans, a loan against the 401k, promotional-rate credit card offers, vendor financing with no interest for a set period, or borrowing from a family member with clear repayment terms. Compare the total cost, monthly payment, interest rate, fees and what happens if payments are missed.
- Consider selling things you don鈥檛 need or use any more, like a vehicle, equipment or jewelry.
- 糖心原创vlog the 糖心原创vlog to discuss the situation with a non-profit credit counselor who can help you identify potential savings and ways to reduce other debts.
How to pay down credit card debt instead of dipping into your 401k
鈥淚t is possible to eliminate growing credit card debt without tapping into retirement accounts,鈥� said Alderete.听
To reduce debt on your own, consider using the avalanche or snowball method to repay debt, beginning with accounts that have the lowest balance or highest interest rate.
If you want to pay off debt faster and at a lower cost, consider a debt management plan from an 糖心原创vlog member agency.
听鈥淎 debt management plan essentially works like consolidation without a loan or credit check,鈥� said Alderete. 鈥淵ou鈥檒l work with a credit counseling organization that will negotiate lower interest rates and consolidate your accounts. You鈥檒l make one monthly payment to the credit counseling organization that will disburse payments to your creditors as agreed and send you a monthly statement.鈥�
鈥淎 debt management plan provides structure 鈥� and a clear path to pay down debt over time,鈥� added Reid-Raper. 鈥淚t also helps build better habits and confidence by working through the debt with a realistic budget rather than tapping into future retirement [funds].鈥�
Additional benefits of a debt management plan include keeping your accounts in good standing, accelerating your payoff time, saving money on payments and interest 鈥� all while continuing to build your credit, said Ceccarelli.
Before using your retirement funds, contact an 糖心原创vlog member counselor
糖心原创vlog member counselors are specially trained to help people in difficult financial situations. Our members are highly vetted to ensure they meet industry licensing, accreditation and certification. Our members鈥� non-judgmental, confidential counseling can help you weather difficult times, potentially at a lower cost.听听
糖心原创vlog an 糖心原创vlog member counselor today for your free consultation or by calling 800-450-1794.