In times of financial hardship and limited options, it can be challenging to turn a blind eye to a supply of money reserved for something as abstract as the future. A withdrawal from a workplace 401(k) plan, whether it be a permanent distribution or temporary loan, is allowable in certain circumstances and recent data from Bank of America shows that more participants are taking advantage: hardship withdrawals are up 36% from the second quarter of 2022, and plan loans have increased as well.
However, a 2020 survey by Edelman Financial Engines found that 55% of individuals who took a withdrawal from their account during the pandemic regretted the move, despite the government having paused the withdrawal penalty in an effort to make the funds more accessible. Those who responded to the survey felt that the consequences of a withdrawal weren’t fully understood.
Hardship withdrawals and early withdrawals
There are three ways in which to remove funds from a workplace 401(k) plan: a hardship withdrawal, early withdrawal, or a loan. Not all withdrawal methods are available for every plan; it is up to the employer whether to make these options available to participants. A hardship withdrawal is a permanent distribution from an individual’s account necessitated by a heavy and immediate financial need. The definition of “heavy and immediate” can vary by plan but includes reasons such as medical expenses and payments to prevent foreclosure or eviction from a home. The permissible withdrawal amount is limited to the amount necessary to satisfy the need. Although there are some exceptions, if the individual is under age 59 ½ they will be subject to a 10% early withdrawal penalty. Furthermore, there may be an unhappy surprise at tax time as the distribution is taxed as ordinary income.
An early withdrawal differs from a hardship withdrawal in that the participant does not have to have a heavy and immediate financial need. An example of an early withdrawal is deciding to cash out a workplace retirement plan upon leaving a job rather than rolling the funds into another qualified retirement plan. Like a hardship withdrawal, an early withdrawal is a permanent distribution that cannot be paid back. It is subject to a 10% early withdrawal penalty if the participant is under age 59 ½ (55 if leaving a job) and is taxable as income as well.
Loans
Alternatively, a 401(k) plan may permit participants to borrow funds. If the participant is able to repay the loan, it is a more attractive option than a withdrawal because the loan amount is not subject to penalties, and it is not includible in taxable income. Furthermore, the money in the account can be replaced and while the loan must be repaid with interest, the interest is paid back to the participant’s plan as they are essentially borrowing from themselves. The typical repayment term is 5 years however it may be extended if used to purchase a principal residence. The allowable loan amount is determined by your employer however the IRS sets amaximum of the lesser of 50% of the vested account balance or $50,000. Some, but not all, plans will allow for a loan of $10,000 if 50% of the vested account balance is less than $10,000.
Potential consequences
While the immediacy and availability of 401(k) assets are attractive, the decision to take a withdrawal or loan should not be made lightly. There are several key considerations that must be taken into account. First and foremost, withdrawing funds disrupts the long-term growth potential of those investments and can significantly impact the overall value of a retirement portfolio. When funds are removed, individuals lose the opportunity for those funds to grow and accumulate returns over the years. The hardship and early withdrawal amounts cannot be replaced, and some plans may disallow contributions while there is an outstanding loan balance. These factors may roll back years of progress, prevent future growth, or impede one from achieving one’s retirement goals.
While interest on a loan does go back into the individual’s account, the interest is usually lower than what could have earned through regular market returns. Therefore, the true cost of a withdrawal includes not only the penalties and taxes paid but also the potential lost earnings on the borrowed amount.
If an individual is laid off or leaves their job with an outstanding loan balance, the balance must be repaid by the tax-filing deadline of the year of separation or rolled over into an eligible retirement account. While this timeframe may seem short, it is in fact an extended grace period that was part of the Tax Cuts and Jobs Act passed in 2017 and set to expire in 2025. At expiration, it’s likely that the deadline for repayment will revert to the original period of just 60 days. If the loan cannot be repaid, it is treated as a distribution and is subject to the 10% early withdrawal penalty if under 59 ½ and is includible in taxable income.
In conclusion, withdrawing assets from a workplace 401(k) is a decision that should be made with careful weighing of short-term needs, long-term financial goals, and potential consequences of not being able to repay the loan in the event of job loss or other circumstances. It is important to explore and understand all alternative options as well as the behaviors and attitudes that may have contributed to needing to tap these funds in the first place. Your Vision Capital Client Relationship Manager is here to provide valuable guidance tailored to your individual circumstances to help you make informed choices that align with your broader financial objectives.
