An emergency can strike when you least expect it. Maybe your car breaks down, or medical bills start piling up. Whatever the reason, it can be frustrating, especially if you are short on funds.
Situations like that may make you wonder if cashing out your 401(k) is the right move. Typically, people have a significant amount of money in a 401(k), so tapping it when disaster strikes may seem reasonable.
But, there are caveats to cashing out your 401(k), and the penalties can be costly. If you are wondering whether cashing out your 401(k) is the right move, here’s what you need to know.
Early Withdrawal Penalties and Tax Implications
If you are dead set on cashing out your 401(k), and you aren’t yet 59 ½ years old, you are going to pay a penalty. The federal government imposes a 10 percent penalty on early withdrawals, which can amount to a significant sum of money.
Additionally, you’ll have to pay taxes on the amount you withdraw. Usually, your income bracket impacts the total you’ll owe, so the exact amount varies depending on your unique situation.
Before cashing out your 401(k), it’s wise to calculate the total of the penalties and taxes. This lets you know how much of the money you’ll actually get to keep.
Alternatives to Cashing Out Your 401(k)
Luckily, there are alternatives to cashing out your 401(k). In some cases, you can make a hardship withdrawal, which allows you to avoid the 10 percent penalty.
Some hardships that may qualify include unreimbursed medical expenses, avoiding foreclosure or eviction, funeral expenses, and certain home repairs. However, it is critical that you determine whether you are eligible in advance, or you may be stuck with the penalty once you make the withdrawal.
Some 401(k)s also allow investors to take out a loan against the funds. There can be limits to the amount that can be borrowed, such as only 50 percent of the vested balance or no more than $50,000.
Additionally, you have to repay these funds, just like you would with any other loan. Typical repayment plans span five years, and interest payments are part of the arrangement. However, the interest does end up in your 401(k), so, in a way, you’re paying interest to yourself.
You may not be able to make additional contributions while the loan is in repayment, so you need to check with the institution that manages your 401(k) to find out for certain.
Is Cashing Out Your 401(k) the Right Move?
Ultimately, only you know what is right for you. Everyone’s situation is different, and you may have an emergency that requires your immediate attention. But, it is smart to explore alternatives, including hardship withdrawals and loans. At a minimum, they may help you avoid specific penalties, so they are worth checking out.
What methods have you used to manage a financial emergency? Share in the comments section below.
Can’t get enough of Engineer Your Finances? Here are a few more articles worth checking out: