Think Twice Before You Tap Your 401(k) Early

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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.

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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.