When faced with a financial emergency, Americans are increasingly tapping their retirement accounts to come up with the cash.
Last year, some 4.8% of plan participants took hardship withdrawals from 401(k) plans, according to Vanguard, up from 3.6% in 2023.
As Vanguard researchers note, the prevalence of automatic enrollment means that more workers than ever now have workplace plans — especially those with inconsistent or unreliable income. And legislative changes have made it easier than ever to make a hardship withdrawal, which allows investors to take money out of retirement accounts penalty-free provided its used for an “immediate and heavy” financial need.
If something like that comes up, it can be tempting to look toward the (hopefully) big pile of money you have saved for retirement to see you through it. But generally speaking, you should look elsewhere, says Paul Brahim, a certified financial planner and president of the Financial Planning Association.
“It should really only be a last resort,” he says.
If you need money in a pinch, your retirement account is a bad choice for a couple reasons, Brahim says.
For one thing, any money that you take out of a traditional 401(k) before age 59 ½ is subject to income tax. Plus if the money isn’t taken out to deal with a hardship, such as medical or funeral expenses, you’ll owe an extra 10% penalty.
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Plus, he says “the amount you took out is no longer compounding toward your retirement,” he says. It doesn’t take too long playing around with a compound interest calculator to see that any dollar you take out now is going to be worth much more to you by the time you’re ready to retire.
“It’s a very, very expensive way to access money,” Brahim says.
So what are the alternatives?
Ideally, it’s your emergency fund. Financial pros generally recommend stashing three to six months’ worth of expenses in cash for when pressing money situations arise. That way, you don’t have to derail your other plans to come up with the cash.
If putting aside that much cash sounds daunting, even a relatively modest cash cushion can help. Plan participants with $2,000 set aside tended to contribute more to retirement accounts and were far less likely to make early withdrawals, according to recent research from Vanguard.
If an emergency fund isn’t an option though, there are still other moves to consider before tapping your retirement funds, experts say.
401(k) loan
Rules vary from employer to employer, but many will allow you to take a loan from your 401(k) plan. You can typically borrow the lesser of $50,000 or 50% of the vested balance of your account. From there, you’ll generally have five years to pay the loan back, with interest — generally at a rate of 1% to 2% plus the prime rate, currently about 7.5%.
The upside here is that you can access some money now without a major tax implication and pay yourself back over time.
There are some drawbacks. Leave your company and your entire balance comes due at once. If you can’t come up with the cash to pay it off, the amount you owe is treated as a withdrawal — subject to tax and a 10% penalty. The same thing happens if you miss the 5-year deadline.
And while the money you put into your account is tax-exempt, you pay back your loan with post-tax dollars. Then you pay tax when you eventually withdraw the money.
“That money is essentially double-taxed at retirement,” Brahim says.
Tapping home equity
If you own a home, you may be able to tap your equity — the difference between your home’s market value and the balance on your mortgage, or, more simply, the portion of your house you own outright — for cash.
A home equity loan is essentially a second mortgage borrowed against your property. You can generally receive between 80% to 85% of your home’s value to be paid back to your lender at a fixed rate — currently 8.22%, on average, according to Bankrate.
“It’s a quick way to get cash without a tax implication,” says Eric Bond, president of Octave Wealth Management. “You don’t have to sell anything, and it’s cheaper than using a credit card.” (The average interest rate on credit cards is more than 20%, according to Bankrate.)
While a home equity loan provides a lump sum to be paid back at a fixed rate, a similar vehicle known as a home equity line of credit (HELOC) comes with a variable rate and behaves more like a credit card, with an available amount of credit that replenishes when you make monthly payments.
Whether one or the other makes sense for you depends on the nature of your emergency, says Bond.
As with any loan, home equity products come with risks, such as damage to your credit or even losing your home if you fail to pay them back on time.
Absent an emergency fund, you’ll be left with unattractive options if you find yourself in a tricky financial situation, says Brahim. That’s why it’s important to plan and save for these scenarios, he says.
“That way, you can let your retirement plan do what it’s supposed to do,” he says.
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