Last October, 25,000 Americans robbed their own retirements.
According to a report from brokerage firm Vanguard, that's how many people took a "hardship withdrawal" from their 401(k) retirement plan. That's the largest number of hardship withdrawals since 2004.
It's a turnaround from positive news that I (Laura Bente) shared last summer... that Americans were adding more money than ever to their 401(k)s. At the time, I explained why a 401(k) is one of the greatest ways to save for your retirement. And if your employer offers matching contributions, not investing in your 401(k) is like giving up free money.
But high inflation has hurt people. Almost everything – from energy to groceries – has gotten more expensive over the past year. And it's leading people to take drastic steps to afford essentials... like taking money from their retirement.
Sometimes life doesn't give you any other option... But if you can avoid it, you don't want to take an early withdrawal from your 401(k). As I'll explain, it will cost more than just the amount you need to spend...
When you want to make a hardship withdrawal, the first step is proving to your employer that you have an "immediate and heavy financial need." This covers expenses like medical bills or paying housing costs to avoid eviction. Once your employer confirms you qualify, you'll get the specific amount you need, plus any extra to cover the taxes you'll owe.
And that amount can be a big deal...
If you're younger than 59 and a half years old, you owe a 10% early withdrawal penalty in most cases. Plus, you have to pay federal and (if applicable) state income taxes on your withdrawal.
Let's say you need to withdraw funds for medical care and you don't have any other way to cover this cost. For a $10,000 withdrawal, your early withdrawal penalty costs you $1,000. If you're in the 22% federal tax bracket, this withdrawal costs you $2,200 in taxes. And if you pay 8% in state income tax, that's another $800.
That means you're paying 40% of your withdrawal amount in taxes and fees. So from that $10,000 withdrawal, you'll only actually see $6,000.
Plus, by withdrawing early, you lose the ability to compound your gains on that $10,000 amount. That leaves you with an even bigger hole once you retire.
Of course, there might be times when someone's financial need is so dire, this could be their only choice. And this could happen regardless of how much money they make. I've heard from people in low and high tax brackets who have found themselves in this position.
But proper planning now could help you avoid a future financial disaster like this.
If you look at your financial life as a house, an emergency fund should be the foundation. You want to make sure that in the event of an accident or job loss, you have the funds available to pay your expenses.
Most Americans don't have this first step in order. According to a Prudential survey, 50% of Americans have less than $500 in an emergency fund.
As I've mentioned, contributing the maximum amount to your 401(k) – which is $22,500 for 2023 – is an essential part of your future financial freedom. But that shouldn't be at the expense of your wealth today.
Take time to look at your accounts to see where your money is going. If you're maxing out your contribution but you're not putting anything into an emergency fund, ask yourself if you can handle a crisis that hits before you retire.
Typically, financial planners recommend having about three to six months' worth of take-home pay in your emergency fund. We've even seen some recommendations for as much as nine months' worth of pay saved.
How much you need to keep depends on factors like your marital status, whether you have kids, your health, and your job stability. But aim for three months at minimum.
If you don't have that much in your emergency fund, you can temporarily lower your 401(k) contributions until you've beefed up your savings. Once your emergency fund is in good shape, you can up your 401(k) contribution anytime.
If you don't max out your 401(k) contribution but also don't think you have enough in your emergency fund, ask yourself the same question... Do you have at least three months' worth of your income set aside for an emergency?
If not, think about how you can start saving more. That might mean limiting nonessential expenses (like those five streaming services you're subscribed to) and putting that money toward savings... or temporarily reducing how much you're contributing to a retirement account.
But what can you do if the crisis strikes before your emergency fund is in place?
If you have a Roth IRA, that might be a better place to grab money from than your 401(k). Since you've already paid taxes on the money going into a Roth IRA, you don't owe taxes on the money you put in directly... only money you earned within the fund (like dividends, interest, or capital gains). You might also owe a 10% penalty depending on factors like your age and when you first started contributing to your Roth IRA. (You can read more about what counts as a qualified distribution here.)
But even if you have to pay income tax on a small portion of the withdrawal amount and the 10% penalty, it'll be significantly less than paying tax on the entire amount... like you would with the 401(k) hardship withdrawal.
Another option is a loan from your 401(k). If your employer allows loans, you could take up to 50% of your savings (up to $50,000). You won't have to pay taxes or a penalty fee, but you will have to pay the loan back – with interest – within five years. And if you leave your employer, you could have to pay the entire amount back sooner.
The specific terms vary by plan. But, like the Roth IRA distribution, it's a way to avoid paying a huge amount in taxes and penalties.
So before you turn to raiding your retirement for emergencies, get a plan together now to set yourself up to be prepared for the worst. And if the worst happens, see if one of these alternatives works instead.
Is your financial house in order? What steps are you taking to make sure it is? Let us know... [email protected].
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Here's to our health, wealth, and a great retirement,
Laura Bente, CFP®
February 9, 2023