Tapping Your 401(k)
When it Makes Sense--and When it Doesn't--to Access Retirement
Money
By Kara Stefan
 Experts
will invariably tell you not to touch your retirement money
until you retire. And they're absolutely right--in general.
But what about those occasions when you really need cash?
I mean a large sum of cash--for a down payment on a house,
for instance, or to pay your child's college tuition. Experts
sometimes don't leave much room for situations where you failed
to plan and save successfully.
If you own your own home, I'd say a home equity loan is your
best option for borrowing money. First of all, home equity
loan interest is tax deductible. Secondly, as long as you're
working, you've got plenty of time to pay back the loan. Not
true with your retirement nest egg. Once you retire, that's
it.
If you don't own property, however--or other significant
investments--your 401(k) may be your only option. Here are
a few strategies for withdrawing funds, and what to expect
of Uncle Sam.
Flat Out Distribution
This is your worst option, just taking money right out
of the plan. That's because not only will you have to pay
income taxes on the money you withdraw, but you'll also get
hit with a 10% federal tax penalty on all money withdrawn
before age 59½.
Borrow Your Own Money
A recent survey by the consulting firm William
M. Meyer, Inc. found that nearly 70% of all companies offering
a 401(k) plan allow their employees to borrow from the account,
regardless of their age.
Your basic, garden-variety 401(k) plan will allow you to
borrow up to 50% of your account balance. You can use this
money for anything you like, from paying off credit cards
to cavorting in Europe.
Most plans give you five years to pay back the loan or 30
years if the loan is used to help purchase a home. Interest
rates are surprisingly competitive, and, best of all, you
don't have to undergo extensive credit checks--you're borrowing
your own money after all. Also, you avoid both the early withdrawal
penalty and having to pay income tax on the borrowed amount.
A particularly neat trick comes when you pay yourself back.
Even the interest you pay goes into your retirement account.
However, your repayments are automatically deducted from
your paycheck, and that can hurt. Some people stop making
401(k) contributions during the repayment period, because
the double whammy paycheck deduction can be too sizeable a
reduction in your take home pay.
Other things to know ahead of time:
- Your retirement plan isn't going to grow as fast since
you're reducing your account balance by as much as 50%.
- If you quit, get laid off, or fired from your job--you
have to pay back the full loan immediately. Typically, you're
allowed 60 days to make a full repayment, and if you don't,
you'll have to pay income taxes on the outstanding amount.
Broken Home Payout
Believe it or not, another way to tap your 401(k) and avoid
the 10% premature withdrawal penalty is to get a divorce.
That's right, a divorce.
Good idea? No. Will it work? Yes.
The fact is, a court-issued Qualified Domestic Relations
Order (QDRO) allows you to split up a 401(k) account between
both ex-spouses, and neither will have to pay the early withdrawal
penalty. If you don't roll over the assets to your own individual
retirement plan, like an IRA, you will have to pay income
taxes on the distribution. But at least you save yourself
10%.
To initiate all this finagling, you first need to get a copy
of your employer's plan so you know your rights. Then have
your divorce attorney obtain a QDRO, which must be submitted
to the plan administrator for approval. They will either open
a separate account for your ex or pay out a lump sum distribution
in the amount dictated by the court, depending on your instructions.
This option should not be considered unless and until all
other avenues have been exhausted, and while it would be an
ill-advised move to make if you and your spouse are shopping
for your first home together, it may make some sense for a
more mature couple struggling to pay their child's college
expenses.
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