When tapping your 401(k) early is okay
January 28, 2013, 12:13 PM
By Glenn Ruffenach
When it comes to saving for retirement, the advice
is all but universal: Avoid, if at all possible, tapping your 401(k) before you
retire. But according
to Karen Blumenthal of The Wall Street Journal, there are a few instances –
with the emphasis on “few” – when pulling funds early from your nest egg can
make sense.
- Jon Reinfurt
As
we noted recently in this space, “leakage” from retirement savings
represents a hefty chunk of 401(k) assets. A report from HelloWallet, a company
that sells personal-finance and budgeting technology to employers, estimates
that one-quarter of 401(k) participants have, at some point, raided their
accounts to cover non-retirement expenses, including mortgages, college tuition
and credit-card bills. In all, workers withdrew about $70 billion from their
401(k)s for non-retirement needs in 2010, HelloWallet says.
Such withdrawals, of course, usually come with one major drawback: If you’re
under age 59 ½, you owe income tax on the amount you take out, plus a 10%
penalty.Even if you take the withdrawal in the form of a loan, which avoids the penalty, the maneuver has three strikes against it. First, you’re costing yourself a potentially significant amount of interest and investment gains. (If you pull money from your savings, your nest egg is smaller and earns less money.) Second, when borrowing from a retirement account, you pay back loans with after-tax money; in contrast, contributions to 401(k)s are made with pre-tax dollars. And third, interest on those loans isn’t tax deductible.
So, when is it acceptable to put your hand in the cookie jar? If you can borrow judiciously, it could make sense to tap your retirement account for something that is an investment: a house, an education, or eliminating high-cost debt to free up more of your future income for savings.
An important first step, Blumenthal notes, is anticipating whether there might come a time when you need to tap your nest egg before retiring; if that’s the case, you will need to save more money in the first place. In this way, you’ll have something of a cushion and still be able to provide for your retirement.
Yes, leakage from retirement savings can be problematic. But some people – again, with proper planning – might have sufficient reason to dip into their 401(k) before retiring. Blumenthal quotes Steve Utkus, director of the Vanguard Center for Retirement Research, an arm of the Vanguard Group: “One person’s leakage is another person’s safety valve.”
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