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Tapping your 401(k)

Published: Aug 31, 2004 8:52 p.m. ET


It is a good idea only under right circumstances



BOSTON (CBS.MW) -- Should you withdraw money from your 401(k) account while you are working?

Customer service representatives, who staff call centers that provide assistance via toll free telephone lines, say that withdrawal and loan requests and related service questions are consuming a greater portion of their time.

And more employees with 401(k) accounts are taking hardship withdrawals, which allow individuals to take money from their retirement plans while they are still working with their employer, under certain conditions.

It appears that employees with 401(k) plans have mastered the art of the withdrawal.

Whether or not it's a good idea to take a withdrawal from your 401(k) plan account depends on what you are doing with the money.

Most retirement experts will say to never take money from your 401(k) plan because you are taking money away from what you will need for a financially secure retirement.

Another good reason to not strip cash from your retirement plan is that when you take money out, you will be paying more income taxes sooner than you have to. That's one reason why it may be best to leave the money that will eventually have to be paid to the IRS in a retirement plan earning interest for as long as possible.

But if the ultimate measure of your financial well-being is your net worth, then taking cash from your 401(k) plan to pay off debt may make sense.

While those funds taken from your 401(k) plan could stay invested and earn a rate of return, if the debt you are carrying is costing you 18 percent, taking money from your 401(k) to pay down that debt is the same as earning an 18 percent rate of return.

Here is another simple example: Let's say you want to buy a home, but you don't have enough cash for the down payment to get a good mortgage. Your choices include: getting a nonconforming mortgage with a higher interest rate and mortgage insurance, waiting until you save the down payment and miss out on the home and low mortgage interest rates or withdrawing or borrowing the cash from your 401(k) account in order to get the house and the low rate mortgage.

In this case, the easy answer is "c".

Loan vs. withdrawal

The advantage of taking a loan from your 401(k), when it's used to secure or purchase a primary residence, is that the loan can be paid back over 15 years, or over the term of the mortgage for the home. The loan is qualified as a "principal residence loan" and the interest paid qualifies as an itemized deduction as "qualified residence interest."

If you instead take a "hardship withdrawal" from your 401(k), which is permitted for the purchase of a primary residence, then the amounts withdrawn are taxable as income and an additional 10 percent penalty tax is also applicable. Also, hardship withdrawals cannot be paid back into the 401(k) plan.

If your 401(k) plan allows you to take a loan for one of these situations, then take the loan. Unlike hardship withdrawals, amounts borrowed through a 401(k) plan loan are not taxable as income unless the balance goes unpaid.

An exception to this strategy is that individuals with a 401(k) who are no longer with their former employer typically cannot take a loan. Instead, they can transfer their 401(k) account to an IRA and then take hardship withdrawals that are free from the 10 percent penalty for early distributions if they are for things like medical expenses allowed as an itemized deduction, qualified education costs and qualified first-time homebuyer expenses.

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