In an earlier posting (The Loan Ranger: Borrowing from Your 401(k) Plan), I wrote about taking a loan out of your 401(k) plan. I thought I’d do a companion piece here about taking a hardship withdrawal from your 401(k) plan.
DON’T DO IT!!! (That sums it up -- end of Insight!)
OK, I guess I’ll beef this up a little.
Back in the days when 401(k) plans were new, some people would not want to contribute because they could not get at their savings until they retired. That’s because 401(k) plans were set up under rules designed for retirement plans, and those plans (oddly enough) weren’t supposed to pay out until you retired.
Then some Brainiac came up with the idea of a hardship withdrawal, which said that, if you really had a hardship, you could withdraw what you put in, but not what you had earned. At first, there wasn’t any guidance about what constituted a hardship, so the prevailing attitude was to let the good times roll, and participants got withdrawals if their pony didn’t win at the track.
Then, the law was changed to say that the withdrawal had to be for an immediate and heavy financial need, and the amount that could be withdrawn was only the amount necessary to satisfy that need. (Yes, yes, I know it’s more complicated than this, but let’s not miss the point). The regulations gave us the safe harbors that most everyone relies on for their withdrawals, and away we went.
Unfortunately, what many would-be withdrawers miss is that there’s a fairly hefty cost to take these withdrawals. The most obvious cost is the 10% excise tax on the hardship withdrawal, so beware -- if you want to take out $5,000 for Johnny’s tuition, there’s a $500 excise tax you’ll have to pay, plus the 28% tax on ordinary income which will cost you another $1,400.
And, just to up the ante, that extra income might put you in the 36% bracket, which will cost you another $400. So, by my math, your $5,000 withdrawal could leave you with as little as $2,700 after taxes. Think about that. You put in $5,000 of your hard-earned dollars. What you get in return is $2,700. Does that sound like a good deal to you?
Beyond the tax cost is the opportunity cost. If you take out $5,000, that’s eating into what you need for retirement. If you’re, say, 45 years old that $5,000 would grow to $13,266 at 5% interest for 20 years (sad to say, $13,266 would be a significant chunk of most people’s retirement savings). It won’t grow to that if you’ve spent it. Also, most plans will say you can’t contribute anything for 6 months after the hardship, so there are some more contributions that won’t have a chance to grow.
All that adds up to smaller savings at retirement. (Of course you were going to replace that money through higher contributions…at some point…later).
Do I think all hardship withdrawals should be banned? No.
If you need a kidney transplant to save your life, and a hardship is the only way to get that done, then of course you take the withdrawal. That’s a true hardship. Retirement savings don’t do you a lot of good if you’re not around.
Unfortunately, though, I’ve seen other hardship withdrawals where I’d say it probably wasn’t the smartest financial choice. For example, if it’s to buy more house than you should, then I’d say it’s a bad idea. If you have other assets, but want the hardship because it’s easier, then it’s a really bad idea. Take a loan instead, and pay yourself back.
Hardship withdrawals from your 401(k) plan? DON’T DO IT!!! You’ll thank yourself in about 20 years.