Should I Close My 401(k) and Withdraw My Funds?

Money saved in a 401k plan has multiple benefits, often growing unnoticed through pre-tax payroll deductions and employer matches.

It can be a comfort to see just how much you save in a 401k year-to-year, but those savings can also be a temptation when unexpected issues leave you in serious financial binds.

Facing an economic crisis, you might be tempted to take money out of your 401k early or even close the account, especially if you’ve amassed a healthy balance.

Just know that financial planners typically offer one word of advice: “Don’t!”

“Borrowing from a 401k can be a tempting option because it provides access to funds quickly and without a credit check,” Andrew Latham, a certified financial planner and Managing Editor at SuperMoney.com, said. “However, borrowing from your 401k should be considered carefully due to the potential impact on your long-term retirement savings.”

When the federal government temporarily removed penalties for early withdrawal during Covid-19, even then taking money out of a 401k had major downsides.

A 401k account is a vital part of your future. It’s your pot of gold at the end of the rainbow (retirement). There are two good reasons not to toy with it even during a national crisis:

• The value of stocks and mutual funds typically plummet during a crisis. Your investment might already have lost significant value during a market downturn, meaning you already have significantly less money to borrow from.
• Less money in the account means you definitely will lose out on the gains from compounding interest that make long-term investing so attractive.

Can I Withdraw From My 401k Early?

 If the alternatives to making an early withdrawal aren’t available to you – personal loans, home equity loans, using funds from a Roth IRA – it’s possible to dip into your 401k if you meet certain requirements.

You should first consult with a financial planner and your plan provider to understand the rules and ramifications of an early 401k withdrawal:

• The IRS levies a 10% penalty on all non-exempt withdrawals before the age of 59 ½.
• Since pre-taxed money funded your 401k account, your withdrawal is taxed.
• The money you withdraw stops working for you.

Latham uses the example of a 35-year-old who takes $5,000 from a 401k to deal with an unexpected financial burden.

“The true cost isn’t just the $5,000,” he said. “It’s the lost opportunity for that money to grow over time. Assuming an average annual return of 7%, by the time you reach 60, that $5,000 could have grown to approximately $27,140.”

401k Withdrawal Rules

The general rules governing a 401k allow you to make penalty-free withdrawals from retirement accounts only after reaching the age of 59 ½. Beyond that, an IRS rule mandates required minimum distributions (RMD) that begin after the age of 73.

If you take money out of your 401k early, the IRS requires a minimum withholding of 20%. In addition, it levies a 10% early withdrawal penalty.

If that seems prohibitive, it’s because it is prohibitive.

In certain situations, however, an individual might be able to withdraw funds from a 401k account early without penalty:

• You leave your job in the year you turn 55 or after (50 for certain federal job designations)
• You become disabled
• A divorce ruling mandates splitting a 401k
• The birth of a child or the adoption of a child
• The money paid an IRS levy
• You are a military reservist called to active duty
• You over-contributed to a 401k account
• You were the victim of a disaster for which the IRS granted relief
• You rolled the account over to another retirement plan

Stuff happens in people’s lives, sometimes serious stuff that leaves them with few good financial options.

It’s always a good idea to check with a financial planner and the 401k plan provider to understand available options, including hardship distributions.

Just know that while you might have an early withdrawal penalty waived under certain circumstances, that money you take out is subject to taxation.

Hardship Distributions from 401k Plan

If you are younger than 59 ½, you need to demonstrate that you have an approved financial hardship to get money from your 401k account without penalty. And that’s only if your employer’s retirement plan allows it. The plan provider is not required to offer hardship distributions, so the first step is to ask the Human Resources department if this is even possible.

If it is, the employer can choose which of the following IRS approved categories it allows for hardship distribution:

• Certain medical expenses
• Costs relating to purchase of a principal residence
• Tuition and related education expenses
• Payments necessary to prevent eviction from or foreclosure on a principal residence
• Funeral expenses
• Certain expenses for repairs to a principal residence

The only other way to get access to your funds is to leave your employer.

Borrowing Money from My 401k

Borrowing from your retirement accounts for DIY debt consolidation may seem like an easy way to get out of debt but you can only borrow $50,000 or half the vested balance in your account, whichever is less.

”Borrowing from a 401k can be an option in certain situations, as it allows you to access funds without incurring early withdrawal penalties,” Alex Call, Partner and Senior Advisor at Peterson Wealth in Orem, Utah, said. “However, there are potential drawbacks to be aware of.”

Call’s list of drawbacks to borrowing from a 401k go beyond the obvious – that you must repay the loan with interest.

One is default. If you can’t repay the loan, you could face the tax consequences and penalties associated with early withdrawals.

“Another is job loss,” Call said. “If you leave your job before repaying the loan, you may be required to pay it back in full, typically within 60 to 90 days. If you don’t, it’s considered a distribution with penalty and tax consequences.”

Unlike a home equity loan where payments can be drawn out over a 10-to-30-year period, most 401k loans need to be paid back on a shorter timetable – like five years.

This can take a huge chunk out of your paycheck, causing even further financial distress. Borrowing money from your 401k limits the kind of growth that comes with compound interest and market gains.

Paying off some of your debt with a 401k loan could help improve your debt-to-income ratio, (DTI) a calculation lenders make to determine how much debt you can handle. If you’re close to qualifying for a consolidation or home equity loan, but your DTI ratio is too high, a small loan from your retirement account, amortized over five years at a low interest rate may make the difference.

Steve Sexton, a retirement planning expert with Sexton Advisory Group in Temecula, California, relates a personal story to demonstrate that borrowing against a 401k should be a “last resort.”

“Twenty years ago, I was recovering from cancer and was out of work,” Sexton said. “We had already negotiated down medical bills, reduced our spending, and essentially used up our cash reserves.

“The only asset I had left was to withdraw funds from my 401k to support my family until I went back to work. This was a unique situation and I had exhausted all my other options. I typically recommend not to borrow, because you give up the compounding you could receive by leaving the money in your 401k.”

Disadvantages of Closing Your 401k

The IRS allows individuals to cash out their 401k and roll it over to an IRA without penalty and without the cashed-out amount being subject to taxation.

You can also close out a 401k without penalty when you leave your job if you are at least 55 years old, but taxes will apply to the amount you withdraw. “If you are in the 22% tax bracket and are charged that additional 10% penalty, which would be an automatic 32% cut on your money just for federal taxes,” Kendall Meade, a certified financial planner with SoFi in Charleston, South Carolina, said. “Then you would also potentially owe state taxes.”

Beyond that, closing a 401k has a number of disadvantages:

• The IRS levies a 10% penalty.
• The money you withdraw is treated as taxable income, potentially at a higher tax rate.
• The investment potential of pre-tax deductions, employer matches and compound interest are lost when you close out a 401k.
• Money removed from a 401k account is no longer protected from creditors in case of bankruptcy.

Cashing out Your 401k while Still Employed

Typically, you can’t close an employer-sponsored 401k while you’re still working there. You could elect to suspend payroll deductions but would lose the pre-tax benefits and any employer matches.

In some cases, if your employer allows, you can make an in-service withdrawal if you’ve reached the age of 59 ½.

Such funds can be used to cover a qualifying hardship. But you might also request an in-service withdrawal if your 401k plan offers few investment options, or you’re not satisfied with the options. You might consider expanding your options by rolling your 401k into an IRA.

What Happens If I Stop Contributing to My 401k?

If you’re considering stopping contributions to a 401k, it’s better to merely suspend those contributions. A short-term suspension will slow the performance of your retirement fund, but it won’t keep it from growing. It also will lessen the temptation to simply withdraw all the funds and erase retirement savings in the process.

Your Retirement Money Is Safe from Creditors

Did you know money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe.

If you’re having problems managing your debt, it’s better to seek advice from a nonprofit credit counselor who can provide alternative solutions other than an early withdrawal, which will also come with a high penalty.

Rolling 401k into IRA

When you leave an employer, you have several options, including rolling your 401k over into an IRA account.

It’s possible to do the same thing while still working for an employer, but only if the rules governing your workplace 401k allow for it.

The negative for rolling the money into an IRA is that you can’t borrow from a traditional IRA account.

Another option when you leave an employer is to simply leave the 401k account where it is until you are ready to retire. You also could transfer your old 401k into your new employer’s retirement account.

If you are at least 59 ½ years old, you could take a lump-sum distribution without penalty, but there would be income tax consequences.

Withdrawing from a Roth 401k

Most 401k plans involve “pre-tax” contributions, but some allow for Roth contributions, meaning those made after taxes already have been paid.

The benefit of making a Roth contribution to your 401k plan is that you already have paid the taxes and, when you withdraw the money, there is no tax on the amount gained as long as you meet these two provisions:

1. You withdraw the money at least five years after your first contribution to the Roth account.
2. You are older than 59 ½ or you became disabled, or the money goes to someone who is the beneficiary after your death.

Debt Relief Without Closing My 401k

Before borrowing money from your retirement account, consider other options like nonprofit credit counseling or a home equity loan. You may be able to access a nonprofit debt management plan where your payments are consolidated, without having to take out a new loan.

A credit counselor can review your income and expenses and see if you qualify for debt consolidation without taking out a new loan.

As they say, life comes at you fast. But help can be just a phone call away.

“If you’re facing financial difficulties, contacting a financial advisor or credit counseling service can provide guidance and support in managing your situation,” Call said.