You never know when a financial emergency might strike. Your car might break down. Your roof might spring a leak. And then there's the possibility of losing your job and having your income disappear overnight. If you're in a financial crunch, you may be tempted to tap your 401(k) for the cash you need. The question is: Is that a smart move?
Don't confuse your retirement savings and emergency savings
It's understandable that you'd want to raid your 401(k) in a pinch. But if you have an emergency fund, that's where the money to cover unforeseen expenses should come from -- not your retirement savings.
Now, if you don't have an emergency fund, you're in pretty good company. An estimated 40% of U.S. adults don't have the money available to cover a $400 emergency, according to the Federal Reserve Board. But even if you're missing that safety net, you should still explore other means of getting that cash before removing it from your 401(k).
The problem with early 401(k) withdrawals
What's so bad about removing funds prematurely from a 401(k)? A lot, actually. Unless your savings are housed in a Roth-style account, you'll face a 10% early withdrawal penalty on distributions you take before reaching age 59 1/2. This means that if you remove $10,000 to cover a home repair, you'll immediately lose $1,000 of it. You'll also pay taxes on that withdrawal, though to be fair, the same would hold true for distributions taken after 59 1/2.
But penalties aside, the problem with taking early 401(k) withdrawals is missing out on the money you remove during retirement, when you need it the most. You lose the principal amount you withdraw early, as well as whatever growth that sum could've achieved.
Imagine your 401(k) investments currently generate an average annual 7% return each year. If you take a $10,000 withdrawal at age 40 to cover an immediate need, and then retire at 67, you won't just have $10,000 less to work with at that point. Rather, your ending 401(k) balance will be $62,000 less when you factor in growth on that $10,000 over a 27-year period. And that's a lot of money to give up, which is why it's generally a bad idea to access your retirement dollars during your working years -- even if you think you need them.
So what should you do if an emergency strikes, you don't have the money to pay for it in the bank, and you're sitting on a 401(k)? For one thing, try immediately cutting back on expenses to free up cash in your budget. Depending on the expense, that just might do the trick.
There's also the option to get a side job to drum up extra money. Finally, don't discount the possibility of raiding your home and selling off nonessential belongings. If you're desperate for cash, it may be worth selling the video game system you enjoy on occasion but can do without.
Borrow rather than withdraw
If you truly have no choice but to tap your 401(k) for emergencies prior to retirement, then you're better off taking that money out as a loan than as an early withdrawal, provided your plan has that option. With a 401(k) loan, you're still losing out on investment growth, but you're also paying yourself back at whatever interest rate your plan imposes, which means you're not taking quite as much of an overall hit on your ending balance. Just as important, with a 401(k) loan, you're not subjecting yourself to the aforementioned early withdrawal penalty, and that could be a huge amount of savings depending on the amount of money at play.
That said, 401(k) loans are not without risk. If you separate from your employer before paying back your loan, you'll generally have only 90 days to repay it entirely before it's treated as an early withdrawal and penalized accordingly. Still, it's better than a pure withdrawal.
Ultimately, your best move is to always leave your 401(k) alone when you need money and find other ways to manage your expenses, unplanned or otherwise. If you're lacking in emergency savings, let this be your wake-up call to start building that safety net. This way, the next time you find yourself in need of cash, you won't have to contemplate raiding your retirement plan in the first place.