Participating in an employer's 401(k) plan is a good way to set aside funds for the future, especially if your company offers a generous match that helps boost your savings. But new data from investment banking company Natixis reveals that a large chunk of younger workers are making a major mistake on the 401(k) front: removing funds from their plans.
Specifically, 30% of millennials have taken out a 401(k) loan, while 26% have taken an early withdrawal. And the reason for doing so largely boils down to personal debt, with 40% of younger workers tapping their 401(k)s to tackle their outstanding obligations. If you've been thinking about cashing out part of your 401(k), or borrowing against it, to deal with financial issues you're having, you should understand the consequences involved before you make a move you wind up regretting.
The problem with touching your 401(k)
The purpose of a 401(k) is to provide you with income in retirement. Therefore, any funds you remove from that account during your working years won't be available during your golden years.
Not only will you lose out on the principal amount you remove from your account, but you'll also lose out on potential growth that sum could've achieved. Imagine your 401(k) typically generates a 7% yearly return on investment, and that you remove $10,000 from it at age 32. Let's also assume that you plan to retire at 67. Over the course of those 35 years, that $10,000 could've grown into $107,000 based on that 7% growth rate, and that's a substantial chunk of cash to go without.
The other problem with taking an early 401(k) withdrawal is that you'll be charged a 10% penalty for removing funds from your account before age 59-1/2. And while there are some exceptions to this rule, they're pretty hard to qualify for (and having too much personal debt certainly isn't one of them). Furthermore, unless you're saving in a Roth 401(k), your early withdrawal will also be subject to taxes, the exact amount of which will depend on your ordinary income tax bracket. Granted, withdrawals in retirement are taxable as well, but at that point, you don't have to worry about the 10% penalty.
Now if you're going to remove funds early from your 401(k), you're better off doing so in the form of a loan. This way, you'll avoid the aforementioned penalty, and you'll (ideally) eventually replenish those funds so that you're not out the money in retirement.
But there are some drawbacks to going this route, too -- namely, that if you're unable to pay back your loan on time, the amount you borrow will be treated as an early withdrawal, which means you will face that 10% penalty after all. Not only that, but if you borrow from your 401(k) and subsequently lose your job, you'll have just 90 days to replenish those funds or face that dreaded 10% penalty. Therefore, while a 401(k) loan is preferable to an early withdrawal, it's certainly not without risk.
A better solution
A 401(k) isn't meant to serve as a bank account, so don't treat yours like one. Instead, make an effort to build some emergency savings so that when you need money in a pinch, you're not forced to raid your retirement plan. You can do so by cutting expenses in your budget, getting a side job and banking your earnings from it, or both. Ideally, your emergency fund should contain enough money to cover three to six months of essential living expenses. This way, it'll likely suffice in getting you through rough patches so you're not tempted to tap your 401(k).
Now if you're already in debt and are seeking to remove funds from your 401(k) to deal with it, it pays to explore other options. First, try refinancing some of that debt, because by snagging a lower interest rate on it, you might lower your monthly payments. You can also try negotiating with your creditors to make the repayment process more manageable. You can even consider enlisting the help of a debt settlement professional if you've truly gotten in way over your head. Either way, aim to find a way out of that mess before you rush to empty out part of your 401(k). Not only will raiding your retirement plan potentially subject you to penalties, but it'll put you at risk of falling short on savings later in life.