Think Twice Before You Tap Your 401(k) Early
Penalty-free distributions have become more accessible, but they can be detrimental to your retirement security.
With more opportunities to access 401(k) funds penalty-free, workers are increasingly dipping into their retirement savings. But those withdrawals could jeopardize their retirement security.
A recent T. Rowe Price study of more than 2 million participants in workplace retirement plans found a notable rise in the number of workers who are taking hardship withdrawals. Plan providers may permit these withdrawals for an immediate, significant financial need, such as unreimbursed medical expenses, costs related to the purchase of a principal residence (excluding mortgage payments), tuition payments, or funeral costs.
Last year, 2.5% of participants took a hardship distribution, up more than a percentage point from the historical average of the past decade, according to the T. Rowe Price report. The average hardship distribution grew to more than $11,000.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The uptick may stem from a provision in the SECURE Act 2.0 of 2022 that streamlines the process. Plan administrators are no longer required to collect documentation from participants verifying the hardship.
The IRS prohibits you from repaying a hardship distribution. The withdrawal is taxable as income, but the 10% early-withdrawal penalty is waived if the circumstances meet the IRS’s list of exceptions.
Under another SECURE Act 2.0 provision, plan administrators may let participants withdraw up to $1,000 a year to meet emergency expenses. If you take an emergency withdrawal, you’ll pay taxes but avoid the extra 10% penalty.
However, unless you repay the money within three years, you are prohibited from taking another emergency withdrawal for the following three-year period. Only 1.3% of workers had taken an emergency withdrawal of $1,000 or less in 2024, according to the T. Rowe Price study.
A greater portion of plan participants — 20% — opted for a 401(k) loan last year, with an average loan balance of more than $10,000.
While fewer Americans are taking loans from their 401(k)s than the highs of 2015 to 2019, the average loan size increased across all age groups.
Generally, if you don’t repay a loan to your account within five years, it’s treated as a distribution and is subject to federal taxes, plus a 10% penalty for individuals younger than 59½ (though there are exceptions if you leave or lose your job at age 55 or older). You may also owe state taxes.
Loan payments, which include the principal and interest (typically the prime rate plus one percentage point), must be made at least quarterly if they’re not automatically deducted from your paycheck.
In addition, payments aren’t considered plan contributions, so you must make separate contributions to be eligible for an employer match, and some employers prohibit match contributions while a loan is in repayment.
Alternatives to tapping your 401(k)
Dipping into your retirement funds may be tempting if you have high-interest debt or face a large expense. But taking money out of your 401(k) early can put a serious dent in its long-term growth, even if you eventually pay it back through a loan.
T. Rowe Price found that workers with more than two loans totaling less than $2,000 from their 401(k) annually had retirement account balances that were 60% smaller than workers of the same age and seniority who had never borrowed from their plan.
The best alternative is to have rainy-day savings on hand. Aim to stash away at least three to six months’ worth of living expenses in a safe, accessible place, such as a high-yield savings account.
If you don’t have enough emergency savings to cover an unexpected expense, a personal loan or a home equity loan, or a line of credit may be a wiser choice than a 401(k) loan or withdrawal.
Lenders will evaluate your credit history when you apply for one of these loans, which may be an obstacle if you don’t have a clean credit profile. And you may pay a higher interest rate than you would on a 401(k) loan. But your retirement account balance will remain untouched, benefiting from long-term, tax-deferred growth.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
Related
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
-
I Retired at 65 With $7.8 Million and Feel Like I Over-Saved. My 40-Something Son Is on the Same Path. Should I Tell Him to Reconsider?We ask financial experts for advice.
-
Deciding on Senior Living? 10 Things You Should KnowSenior living options are no longer God's waiting room.
-
I'm a Financial Pro: This Is How You Can Guide Your Heirs Through the Great Wealth TransferFocus on creating a clear estate plan, communicating your wishes early to avoid family conflict, leaving an ethical will with your values and wisdom and preparing them practically and emotionally.
-
Try This One-Minute Test to Uncover Hidden Health RisksFinding out this little-known fact about your body could reveal your risk of heart disease and more. It's a simple, free check for healthy aging.
-
Child-Free Cruises Perfect For Your Retirement CelebrationHow to find a bespoke ocean or river vacation for adults. Many of these options are smaller, charming river cruises, expeditions, or niche experiences.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
-
2026 Social Security COLA is 2.8%: What You Need to KnowThe SSA has announced the 2026 Cost-of-Living Adjustment (COLA), the new maximum taxable wage cap, and the earnings requirements for Social Security credits.