Withdrawing 401k - know the facts

So you have a 401k account and want to withdraw from it—maybe the need is urgent, maybe it's not as urgent but your 401k is your only pool of money that you feel like you can tap. Let's go over some 401k withdrawing options, given the rules and potential penalties that you'd probably like to avoid. With a little planning, you can minimize your exposure to penalties, taxes and problems with the IRS.

There are 2 possible withdrawal types (you'll have to check with your plan's administrator for the specifics):

• a plan loan: you can often do whatever you want with the money, but there is a maximum (either half of your account's balance or $50,000, whichever is less). Approval is relatively easy for this, but you must begin repaying it back immediately since it really is a loan.
• a hardship withdrawal: you are restricted to certain types of uses for the money, but you can withdraw up to your full account balance; however, there are some major disadvantages to using this option (more on that below). You must also get permission from your plan administrator, usually in the form of a written request explaining exactly what you need the money for, and why you can't tap any other source of money. However, since it is not a loan, you don't have to repay it back.

Plan loans are a good option in terms of simplicity and absence of major disadvantages, if you're sure you're able to repay the loan in a timely manner. But it's worth going over some potential negatives:

• when you withdraw money and pay it back later, you're forgoing any investment growth that that money would have created had it stayed in your account
• you must pay back your loan in regular payments; if you start missing payments, then the remaining balance of what's owed back will be treated as an early taxable distribution and you'll also be subject to a penalty of 10%
• if you lose your job for any reason, you must repay the entire loan within 60 days, or face taxes and the 10% penalty

A plan loan must be repaid. Typically, you'll have up to 5 years to repay your loan and interest (you get to keep the interest in your 401k account, but you must pay it), a bit longer if you use your loan to buy your primary residence. The interest is always at competitive, market rates, and most people who choose a plan loan are set up with automatic repayment deductions from their paycheck.

However, if you leave your employer (either by being let go, or quitting; it doesn't matter how or why), you must pay up your loan within 60 days. Yes, in full within 60 days! If you can't manage to do that, then you'll be taxed on the loan since your loan will be treated as an early, taxable distribution, and you'll have to pay a 10% federal early withdrawal penalty to the IRS. That penalty, unlike the interest you're forced to pay in your repayments, is not put back in your account!

This type of withdrawal--only available for certain, urgent needs--allows you with withdraw up to your entire 401k account balance, but there are significant drawbacks worth mentioning.

What types of hardships qualify? Each 401k plan sets its own guidelines, so you'll have to check with your plan administrator for specifics, but generally they include paying for:

• medical expenses (for you, your spouse, children, dependents or beneficiary)
• funeral/burial expenses (for a parent, spouse, child, dependent, or beneficiary)
• your primary residence
• emergency repairs on your primary residence
• fees and arrears to pull yourself out of eviction/foreclosure from your primary residence
• a year's educational costs (for you, your spouse, children, dependents or beneficiary)
• owed taxes/penalties for making the early withdrawal

You'll have to explain which of these qualifying reasons applies in a written request to your plan administrator, and you'll be asked to provide proof that you can't obtain the money in any other way.

Before you choose this option, keep in mind these important warnings:

• you will have reduced your retirement account balance, one that you would be presumably depending on when you retire
• you can not contribute to a 401k plan for 6 months following a hardship withdrawal
• you're subject to a 10% penalty and must pay tax on the amount withdrawn (for a traditional 401k) or on earnings (for a Roth 401k)

Because of the risks, and potential taxes and penalties, associated with withdrawing from your 401k, it is something you should only consider doing if you truly have no other option and your needs are dire. Buying a new car or paying for a vacation would probably be possible under a plan loan, but they are not advisable. (Buy a used car or opt for a staycation instead, if affordability is the problem).

That said, sometimes tragedy strikes and you need to dip into your own retirement savings. If you find yourself in that place, be sure to know any repayment obligations and tax implications before you take such a step.