There's a reason it makes sense to save for retirement in a 401(k) if you have access to one. Not only do these retirement plans make it easy to stay on track with your savings (since they're funded from your paychecks directly), but many 401(k)s come with a workplace match.
But there's a big drawback to using a 401(k) to save for retirement. If you take a distribution before turning 59 1/2, you'll generally be subject to an early withdrawal penalty of 10%. So if you're 45 and tap your traditional 401(k) plan to the tune of $15,000 to get a new roof, you'll lose $1,500 right off the bat, and your distribution will also be taxable.
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A new rule, however, lets you tap your 401(k) before age 59 1/2 without a penalty. But before you start jumping for joy, it's important to understand how it works.
You can raid your 401(k) early to pay for long-term care insurance premiums
Long-term care is something many older Americans end up needing. And the costs can be astronomical.
Genworth and Care Scout put the average annual cost of assisted living at $70,800. A shared nursing home room, meanwhile, could set you back $111,325 per year, while a private room could cost you $127,750.
Unfortunately, Medicare will not pay for long-term care. So unless you relish the idea of paying those gigantic bills, you may want to buy long-term care insurance in your 50s for protection.
Long-term care insurance, however, isn't cheap. And it may be something you struggle to pay for.
Now, a new rule allows you to take up to $2,600 from your 401(k) this year to pay for long-term care insurance premiums before age 59 1/2 without a penalty. The limit for future years will be indexed for inflation. But that doesn't mean this is the best idea .
For one thing, that $2,600 may not cover your premium costs entirely, depending on the policy you bought. Also, to use this option, your specific 401(k) plan has to allow it.
Furthermore, you can't withdraw more than 10% of your 401(k) balance to cover long-term care insurance premiums. So if you only have $15,000 in your 401(k), you'd be limited to a $1,500 withdrawal.
Should you tap your 401(k) to cover long-term care premiums?
If you want the protection of long-term care insurance and you can't afford those premiums otherwise, then you may be tempted to use your 401(k) to pay for them. But there are some big drawbacks to taking advantage of the new rule.
First, while there's no penalty for taking early withdrawals to cover long-term care premiums, you'll still be taxed on your withdrawals. Also, money you remove from your 401(k) won't be able to grow.
Before you tap your 401(k) to cover long-term care insurance, you may want to price out different policies and see if there's one you can afford without raiding your retirement savings. You should also know that if you have money in a health savings account, you can use it to pay for long-term care insurance. And if so, you get the benefit of not having to pay taxes on that withdrawal.
