If you’ve taken saving for your future seriously, chances are you have a 401(k). In case you’re unfamiliar with the term, a 401(k) is a savings/investing plan from employers that gives you a tax break on any money you set aside for retirement.
Good savers can accumulate a tidy sum in these types of accounts, which can make it awfully tempting to spend. The pervading opinion of most financial advisors is … don’t do it! Here are a few reasons why touching your 401(k) is a bad idea:
- A 10% Penalty Fee
Unless you’re withdrawing money from your 401(k) for one of the reasons listed later in the article, you’ll have to pay a penalty of 10% on that withdrawal if you’re under age 59½.
- Sooner Taxes
If you make a 401(k) withdrawal before age 59½, you’ll also have to pay taxes on the amount you took out. Sure, you’d have to pay taxes on these withdrawals regardless on when you remove the money. But you’ll be paying taxes much sooner and you’re probably in a higher tax bracket than you’ll be when you retire.
- Future Wealth
The interest you earn on your 401(k) is compound interest. Compound interest is what you earn on your savings, plus the interest that money earns. If you reduce the balance of your 401(k), you’ll be putting a dent in that compound interest as well. That means you’ll be earning less money in the future.
- Emergency Funding
Many people don’t have an emergency fund and see their 401(k) as a replacement. Problems arise, however, when people dip into their 401(k) savings to pay for big ticket items like vacation or college. So, the money won’t be there if you really need it one day.
Reasons You Can Use Your 401(k)
Speaking of emergencies, the IRS has outlined six ways you can tap into your 401(k) before age 59½ without penalties:
If something has occurred that causes you to be deemed disabled in the eyes of your insurance company or Social Security, you can withdraw from your 401(k). You’ll need a disability letter to make this happen.
- Medical Bills
A major health emergency can get expensive. You can withdraw from your 401(k) to help with the medical bills as long as you take the money out the same year the medical bills occur. Keep in mind that the withdrawal amount can’t exceed 7.5% of your adjusted gross income.
Live in an area that’s been considered for disaster relief? You can use your 401(k) to pay for disaster-related expenses.
- 55 and Laid Off
Losing your job due to layoffs or buyouts means you might be able to withdraw from your 401(k) – if you were 55 the time it happened. The IRS puts it this way: “Made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55.”
Yeah, this is the most extreme reason a withdrawal can be made penalty-free from a 401(k). If you die, your family beneficiaries can use your retirement funds to cover burial expenses and supplement other income needs due to your death.
It all boils down to this … Don’t use your 401(k) as a piggy bank and you’ll avoid penalty and have a happier retirement.
The above article is for information purposes only and is not intended to be a source of professional advice. Consult your financial advisor and/or tax professional for official 401(k) advice.