One of the basic tenets of personal finance is that your 401(k) is for your retirement and should not be used as an emergency fund.
However, a growing number of people are dipping their hands into their retirement accounts due to major life events like unemployment, sickness or debt, or even for unexpected expenses like a car breakdown.
Unfortunately, most people fail to create an emergency fund, so when an unexpected event arises, they are left with no option but to tap into their retirement funds. What is even worrying is that most people who take money from these accounts have no means to replace the funds they took out.
But what exactly are the consequences of pre-retirement withdrawals?
These withdrawals can lead to a wide variety of adverse consequences ranging from taxes and penalties to lower or even lost investment returns. Over the long term, these withdrawals can dramatically impact your retirement funds. When you borrow funds from your retirement accounts, you may have to forgo investment returns that you cannot get back. When you finally withdraw your money upon retirement, the interest will then be taxed another time. Also, if you are unable to pay off your loan and you default, the balance will be subjected to an early withdrawal penalty plus regular income taxes.
While it is not mandatory for retirement plans to offer hardship withdrawals, the IRS does allow these, but there should be an immediate and heavy financial need. This means that the money withdrawn should only be used to cover for that need and the amount withdrawn should not exceed the amount required to pay for that expense. Some of these withdrawals may be exempt from penalties.
The long and short of it is that you should avoid dipping into your retirement accounts. Instead, build an emergency fund for unforeseen expenses. But what if a pressing situation arises and you find yourself short on cash?
It goes without saying that using your retirement funds for other expenses should be your last option. Besides, if you need to get money fast, accessing your funds is not the best option because you have to wait for a considerably long period of time. Processing time can range anywhere between 10 to 90 business days.
One option that you can look into when you need money is your workplace plan which allows you to borrow up to $50,000. This option enables you to avoid withdrawal penalties because you are simply borrowing money and not withdrawing. On top of that, there is no credit check and the payments can be deducted from your paycheck. Interest rates are also fairly low.