Without savings in an individual retirement account (IRA) or 401(k), you might have a really hard time keeping up with your living costs once you retire and your paycheck disappears. So it's good to learn that as of August, 401(k) balances had increased by $7,250 since the end of 2022, according to data from Bank of America.
That same report, however, found that 401(k) hardship distributions increased 36% on a year-over-year basis. And that's a not-so-favorable statistic.
The problem with 401(k) hardship withdrawals
Some 401(k) plans allow savers to take hardship withdrawals to cope with things like medical bills and unemployment. And it can be tempting to tap your 401(k) plan when unexpected expenses arise. After all, that money is yours, and it's just sitting there. Why apply for a loan when you have savings you can raid?
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But there are several problems with 401(k) hardship withdrawals. First, just because you're taking one of these distributions doesn't mean you won't face an early withdrawal penalty.
Normally, you can't tap a 401(k) without penalty prior to age 59 1/2. So if you take a hardship withdrawal at age 45, you might lose 10% of the sum you remove right off the bat. You might also create a tax liability for yourself since traditional 401(k) withdrawals are subject to taxes.
Furthermore, the more money you remove from your 401(k) ahead of retirement, the less money you stand to have once your career wraps up. That could lead to years of financial struggles.
And remember, due to lost investment gains, a seemingly modest 401(k) withdrawal ahead of retirement could have big consequences. Taking $10,000 out of your 401(k) at age 45 while aiming for a retirement age of 65 could mean shorting yourself on $67,000 if your investments normally give you a 10% average annual return, which is in line with the stock market's average.
There may be another route you can take
It's easy to see why you may be tempted to take a 401(k) hardship withdrawal. But before you do, see whether there's another option for getting your hands on money when you need it.
If you have an emergency fund in a savings account, that should be the first place you look. But even if you have to borrow some money temporarily to get back on your feet, that may be preferable to tapping your 401(k).
A home equity loan, for example, could prove to be a relatively cost-effective way to borrow. And if you don't own a home or have equity in one, the same might hold true for a personal loan if you're a borrower with strong credit. You may also, depending on your circumstances, have a family member you could borrow from.
Finally, if you really have no choice but to tap your 401(k) when a need arises, consider taking out a 401(k) loan rather than an early withdrawal. Doing so is risky in its own right, but at least it won't trigger a 10% early withdrawal penalty, provided you pay it back on schedule.
