Before You Cash Out: Alternative to Draining Your 401(k)


Image by 401(K) 2013

Financial advisors discourage against drawing prematurely from 401(k) retirement funds, characterizing this as a risky last resort, but in today’s economy more Americans are tapping into this option to cover short-term emergencies as well as major purchases. Between 2008 and 2010, the number of Americans with outstanding 401(k) loans climbed to approximately 28 percent, and since then it has remained just shy of this mark, according to HR consulting firm Aon Hewitt. Financial experts such as Charles Schwab Foundation president Carrie Schwab-Pomerantz warn against the potential risks associated with 401(k) loans and withdrawals, which can incur extra interest payments, early withdrawal penalties, increased taxes and lost compounded tax-deferred growth. In light of such risks, Consistent Values president Pam Dumonceau has her financial planning clients brainstorm all other available options before turning to a 401(k) loan. Fortunately, there are other alternatives.

An Ounce of Prevention: Establish an Emergency Savings Account

Part of the problem is that the current financial planning system tends to divert funds employees need for short-term spending into long-term retirement savings, leaving nothing left for immediate emergencies, suggests Matt Fellowes, chief executive officer of financial guidance service HelloWallet. Fellowes suggests that in the current economy, many workers would be better advised to build an emergency savings account that avoids the risks associated with 401(k) plans before investing in retirement savings. Only after establishing an emergency fund should employees focus on retirement planning, he says. Opinions vary on exactly how big an emergency fund should be, and specifics will vary with your situation, but a widely-accepted rule of thumb recommends your savings should be at least enough to cover three to six months of living expenses, with retirees advised to have a year’s worth of funds available. If you feel like you just could never save enough for an emergency fund, CashNetUSA recommends possibly setting aside your tax refund (if you don’t have any debt to pay off).

Other Loan Options

When your savings account doesn’t cover your expenses, you may need to explore loan options, in which case there are various sources you should consider before turning to 401(k) funds. Dumonceau encourages clients considering 401(k) loans to first explore alternatives such as borrowing on a home equity line of credit, taking an unsecured low-interest personal loan, or applying for a credit card with 0 percent interest. Some employers may be persuaded to advance loans, either formally through a contract or informally as a way of building company loyalty.

If You Do Borrow from Your Retirement Funds

What if you do end up needing to resort to borrowing from your retirement funds? In this case, an expert financial advisor may be able to suggest ways you can tap into your funds without incurring standard penalties. Possible strategies include taking back a Roth IRA contribution, taking regular IRA payouts, and tapping an inherited IRA, according to Forbes. Some IRA withdrawal strategies carry their own potential risks, so consult an expert about your specific situation.

The information in this article is provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness or fitness for any particular purpose. The information in this article is not intended to be and does not constitute financial or any other advice. The information in this article is general in nature and is not specific to you the user or anyone else.