Don't forget tax hit when considering early 401(k) withdrawal

by Barry Armstrong 10/06/08

Don't forget tax hit when considering early 401(k) withdrawal
Courtesy of Fosters.com

Editor's note: Money Matters is a new column that will appear every week in the Sunday Citizen business section.

Question: I've used up all of my savings and am considering taking money out of my 401(k). Is this a good idea?

Answer: Taking funds out of your 401(k) should only be considered if you are in immediate need of assistance and you have exhausted all other sources.

Before making a withdrawal, explore all of your options and educate yourself on the financial implications of withdrawing or borrowing funds from your 401(k).

Some employers allow withdrawals for employees that meet a certain criteria. These withdrawals, called hardship withdrawals, include circumstances where individuals use the funds for post-secondary education expenses, costs to purchase a primary residence and medical expenses for themselves or their immediate family.

When a hardship withdrawal is made, the federal 10 percent early withdrawal penalty is typically waived; however, for all other permitted withdrawals, they are taxed as ordinary income and you may be subject to the 10 percent federal penalty if you have not reached age 591⁄2.

If you decide to make a withdrawal, be sure to calculate your net withdrawal. For example, if you are in the 25 percent tax bracket and withdraw $6,000 from your 401(k), the amount received will be reduced by $1,500 for ordinary income tax and an additional $600 for the 10 percent penalty. This leaves you with a net payment of $3,900.

If your employer allows it, you may want to consider taking a loan from your 401(k) rather than a withdrawal. By taking a loan, you essentially borrow the money from your account and pay it back to yourself over time with interest. The amount that you are allowed to borrow would depend on your current account balance but you will not be able to borrow more than 50 percent of total balance.

Your employer allows you to choose the repayment terms (typically up to five years) and your payments will be automatically deducted from your paycheck. Be aware that many employers will not allow you to contribute to your 401(k) plan while you have a loan outstanding, missing out on the company match contribution during that period.

If taking funds out of your 401(k) is your only option, I would recommend a loan versus a withdrawal.

I am not a tax advisor and you should consult with a tax professional in your state concerning your specific situation. Remember that the goal of your retirement account is to let it grow tax deferred for as long as possible to ensure a rewarding and comfortable retirement.

Barry Armstrong is the host of Money Matters with Barry Armstrong on WTSN 1270 and a registered representative with Securities America, Inc. Member FINRA/SIPC.

For a free, no obligation financial consultation, contact Avra Friedfeld at Armstrong Advisory Group at (800) 393-4001

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Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Money Matters Radio and Securities America Inc. are unaffiliated. Representatives of Securities America Inc. do not provide legal or tax advice. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state.

Don't forget tax hit when considering early 401(k) withdrawal

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