By Chris Farrell
This article is reprinted by permission from NextAvenue.org .
Taking money out of your employer’s 401(k) plan while you’re still on its payroll is about to get easier. The federal government’s new rules about “economic hardship” withdrawals from retirement savings plans like 401(k)s go into effect in January 2020.
It’s great that people in a financial crunch will have less trouble tapping their retirement plans if necessary. But one thing hasn’t changed: Pulling money out of your retirement savings before retirement is, generally speaking, a bad idea. That’s why personal finance experts, including me, urge caution before using the new rules to make an early withdrawal.
“Americans, on average, are undersaved for retirement,” says Christine Benz, director of personal finance at Morningstar, the Chicago-based investment research firm. “The idea of prematurely extracting money from a retirement plan in an era when people are undersaved doesn’t seem great.”
What qualifies for early withdrawals from 401(k) plans
The Internal Revenue Service says these types of economic hardship qualify for early withdrawals from employer-sponsored retirement plans:
Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary
Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
Funeral expenses for the employee, the employee’s spouse, children, dependents or beneficiary
Certain expenses to repair damage to the employee’s principal residence
Most medium-to-large companies allow for hardship withdrawals and 401(k) loans, the main alternative for accessing retirement savings while working. (More about 401(k) loans in a moment.)
401(k) early withdrawals vs. loans
If you withdraw money from your retirement plan while you’re working at the employer who offered it, you’ll pay a 10% tax penalty and income taxes on the withdrawn amount in most cases and you don’t need to repay what you take out. But the IRS does allow for penalty-free (not income-tax free) withdrawals under limited conditions, including becoming totally disabled; debt for medical expenses exceeding 7.5% of income and a court order for payments to divorced spouse, child or dependent.
The other way of gaining access to retirement savings early is through a 401(k) loan. The IRS limits such loans to $50,000 or 50% of your retirement savings account balance (whichever is less). The loan generally must be paid back within five years or within six months after you leave your employer. Loans are a popular option since you’re paying yourself back and, assuming the loan is paid off on time, won’t incur an early withdrawal tax penalty or owe income taxes on what you borrow.