Should I Withdraw My 401(k) Funds Early to Cover Expenses?

If the COVID-19 pandemic has stretched your finances too thin, you might be asking yourself, "Should I withdraw my 401(k) earnings to make ends meet?" Although you technically can use your 401(k) funds at any time, you'll likely want to exhaust all other options first. Even during a crisis like COVID-19, tapping your retirement funds today could create further financial hardship in the future.

Should I withdraw my 401(k) earnings now?

Withdrawing from your 401(k) to cover debt expenses usually isn't the best path to take. Although carrying debt can create a significant financial strain, taking out money from your 401(k) early has several downsides.

One is that you'll have less money earning compound interest, which means less money for your retirement. Additionally, if you withdraw money before you're age 59 1/2, you'll be charged a 10% early withdrawal penalty and you'll have to pay income taxes on the amount you take out.

In some instances, you can withdraw funds early and avoid penalties. These include becoming disabled or accruing high medical bills that are difficult to manage on your regular income.

But, if you plan to use your 401(k) to pay down or consolidate high-interest debt, you may want to consider other methods first. A personal loan or home equity loan or line of credit can provide access to cash with competitive interest rates, without jeopardizing your retirement savings. You may even be able to negotiate new repayment terms with your lenders to make your monthly installments more manageable.

When should I consider 401(k) withdrawals?

Ideally, you'd leave your funds in your 401(k) until retirement to maximize your returns. You want to have enough money to ensure a comfortable lifestyle once you retire and to cover medical care and other expenses. If you're struggling financially right now, it's best to look for alternatives before withdrawing from your 401(k).

But, if you're not able to qualify for another loan or don't have home equity, you may need to tap into your 401(k) funds. The IRS allows 401(k) account holders to take hardship distributions under certain circumstances. These may include buying a home, paying for medical or funeral expenses, covering mortgage or rent payments to avoid eviction and paying for college or university tuition.

To qualify for a hardship distribution, you may have to provide your employer with a written statement saying that you can't meet these expenses with your income, insurance or other financial resources. Hardship distributions are taxed as income and are subject to the early withdrawal penalty if you're younger than 59 1/2.

You can get around the penalty, however, if your employer allows you to take out a 401(k) loan rather than withdrawing money outright. The upside of a 401(k) loan is that you repay yourself rather than a lender, and you won't incur the early withdrawal penalty as long as you repay the loan on time.

Be aware, though, that the repayment timeline shrinks from 5 years to as little as 30 days if you leave your job before you've finished repaying. You'll also still miss out on earnings since the amount you borrowed won't accrue as much interest as it would have, even after you pay it back.

Understanding the alternatives

When you're stressed about money, it can be difficult to take a deep breath and see the long view, let alone understand all of your options. Before deciding to withdraw or borrow from your 401(k), you could benefit from speaking with a trusted financial professional. They can walk you through the long-term implications of using your 401(k) early, and they can also suggest alternative paths to coping with debt or freeing up cash. These strategies can serve you post-pandemic as well, as you'll be better equipped to handle emergencies while still building savings for the future.