Saturday, March 1, 2008

401(k) Loans are Risky

There are many things workers need to know when it comes to taking money out of a 401(k). Many of my clients are very surprised to discover that when they cash out a 401(k) early to pay off debt, their employer did not withhold enough taxes. Depending on their tax rate, the taxes and penalties sometimes approach 50% of the withdrawal amount. Many times they will owe money at the end of the tax year.

The risk of dipping into a 401(k) for a loan is great. For whatever reason the employee leaves their employer (through downsizing, layoffs, terminations or a better job), they have a short amount of time to pay back the loan or it will be considered an early withdrawal and be subject to taxes and penalties.

The only time we recommend an early withdrawal from a retirement account is to avoid bankruptcy. If money is needed to pay bills, buy groceries or to keep the lights on, sometimes we need to reevaluate our current style of living.

Some short-term fixes to get back on track include selling things, downsizing a home, selling a car and driving one that is paid for, or working overtime or an extra job. These are things that no one wants to do, but the benefits far outweigh that of a loan or withdrawal from a 401(k) and should buy enough time to get back on track.