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The 401(k) Mistake You Can't Afford to Make

When you're having trouble making ends meet, any source of quick cash looks attractive. Pulling money from your retirement savings, however, comes with high costs -- both now and in the future.

A recent USA Today article reported that many workers are tapping into their 401(k) plan accounts to cover higher mortgage payments and other basic living expenses. Some participants have used 401(k) loans to get access to money -- and that type of loan is getting easier to access. Yet an increasing number of workers are simply taking money directly out of their retirement plans without any intention of paying it back.

Paying the price
In general, most 401(k) plans don't let you take money out while you're still working for your employer. Many plans, however, have provisions that let you make so-called hardship withdrawals for financial emergencies.

Yet these hardship withdrawals carry a steep price tag. When you take money out of your 401(k), you'll have to pay income taxes on it. In addition, the IRS imposes a 10% penalty. So if you're in the 25% tax bracket, taking $10,000 out of your plan would cost you an extra $3,500 in taxes and penalties.

Over the long run, these withdrawals have an even bigger cost: You lose the potential investment gains that come from compounding returns over time. Over 20 years at a 10% return, that $10,000 investment would grow to more than $67,000 -- money that's lost for good.

Lack of confidence
Despite the costs, hardship withdrawals are just one symptom of the difficulties employers face in getting workers to participate in retirement plans. Companies such as Deere (NYSE: DE  ) , United Technologies (NYSE: UTX  ) , and Kraft Foods (NYSE: KFT  ) have faced class-action lawsuits from employees over high plan fees. One company that participated in the Enron and WorldCom suits is reportedly looking into similar fee allegations in Wal-Mart's (NYSE: WMT  ) retirement plans.

In addition, when the stock market is struggling, workers who see their plan balances dropping want to take protective action -- even if it means paying taxes and penalties. Memories of Enron workers who had company stock in their 401(k) plans and lost everything in the company's demise are still fresh in people's minds. And law firms continually pursue companies whose shares are falling -- one firm, for example, has filed recent cases involving Citigroup (NYSE: C  ) and Merrill Lynch (NYSE: MER  ) .

When you consider all of these black marks against 401(k) plans, it's not surprising to see workers giving up on them entirely. However, despite the problems many workers face in their 401(k) plans, they remain an essential tool for retirement savings. The combination of reducing current income tax, getting tax-deferred growth, and often getting company matching contributions is something you won't find with any other investment.

Don't make a big mistake
The worst part of taking hardship withdrawals from your 401(k) is that they're unlikely to solve fundamental problems with your finances. Without taking action to reduce expenses, many families that take 401(k) withdrawals are only delaying the inevitable. To make real progress with your finances, you have to address the underlying issue of spending more than you make. By doing that first, you may actually be able to avoid touching your retirement plan and thereby preserve your prospects for a comfortable retirement.

To learn more about saving for retirement when times are tough, read about:


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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