Tapping Your 401(k)

Tapping Your 401(k)

When it Makes Sense–and When it Doesn’t–to Access Retirement Money

By Kara Stefanfrom_our_columnists

kara_stefanExperts 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have to pay income taxes on the money you withdraw, but you’ll also get hit with a 10% federal tax penalty on all money withdrawn before age 59½.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.