IT’S NOT UNCOMMON TO FIND YOURSELF IN NEED of cash quickly — a major home-renovation need arises, say, or a child’s destination wedding. During your working years, taking money out of your employer-sponsored 401(k) plan account through either a loan or withdrawal (also called a distribution) may feel like your only option for raising funds. “It’s understandable that an individual who needs access to money may consider dipping into their 401(k) plan,” says Kai Walker, managing director, Retirement Research and Inclusion Transformation at Bank of America.

 

But before you decide to pull out your retirement savings early, consider why this could prove to be a costly move — and what your alternatives are. Your financial advisor can also help take your personal situation into account and work with you to determine other potential sources of funds.

 

3 reasons to think twice before taking money out of your 401(k)

1. You could face a high tax bill on early withdrawals

Before you retire, your employer’s 401(k) plan may allow you to tap your funds by taking a withdrawal (plan rules vary, so check). If you’re considering a withdrawal from your 401(k) plan account¹ keep in mind that you may be subject to federal and state income taxes on the amount you take out, as well as an additional 10% federal income tax if you are under age 59½, unless an exception applies, Walker notes.

 

How does the early withdrawal additional tax work? The additional tax is based on the taxable amount of your withdrawal. Let’s say your account consists entirely of tax-deferred funds; taking a $10,000 early distribution results in a $1,000 early withdrawal tax. Meanwhile, the $10,000 counts toward your taxable income, and is subject to state and federal tax based on your tax bracket. Unfortunately, this means that in many circumstances, an early withdrawal nets you only a fraction of the spending power of every dollar you take from retirement savings.

 

What sorts of exceptions exist? Tax rules provide several exceptions to the early withdrawal additional tax, including taking out money to pay for qualified birth or adoption costs or withdrawals in the event of total and permanent disability. Under legislation passed in 2022, the SECURE Act 2.0, the list of exceptions was expanded to include the following:

• Distributions up to $22,000 due to a federally declared natural disaster
• Withdrawals of up to $10,000 for victims of domestic abuse
• Emergency personal expense withdrawals of up to $1,000 per calendar year
• Distributions to a terminally ill employee
• Distributions to purchase long-term care insurance in amounts not to exceed $2,500

 

Your employer is not required to offer any of these distribution options in its employer-sponsored 401(k) plan. However, if you are terminally ill and otherwise eligible for a withdrawal, you may still qualify for the exception to the 10% additional tax. Consult a tax professional for further guidance; frequency limitations, required certifications and other rules may apply in securing an exception to the 10% additional tax.

 

It’s important to note that these taxes apply only to a true withdrawal. When you take out a loan against your 401(k) and repay it, no taxes would be imposed (unless you fail to pay back the loan, as noted below).

 

2. You can be on the hook for a 401(k) loan if you leave your job

Employer-sponsored 401(k) plans may — but aren’t required to — allow account holders to access savings through loans. Plans vary in their loan stipulations; typically, the amount you can borrow depends on the account’s value and maxes out at $50,000.² An advantage of a 401(k) loan over a withdrawal is you don’t pay ordinary income taxes or face potential additional taxes on the borrowed amount. You must repay the loan along with interest, per the loan terms; but on the bright side, repayments replenish your plan account — you’re essentially repaying yourself. 

 

Although you generally have up to five years to repay a 401(k) loan, leaving your job (or losing it) before the loan is repaid may mean you have to pay back what you owe quickly. If you can’t, the loan will go into default and the unpaid balance is considered a distribution (referred to as the loan offset amount). As with an early withdrawal, you may be subject to federal and state income taxes, as well as an additional 10% federal income tax if you are under age 59½, unless an exception applies.

 

However, you may avoid this tax treatment by repaying or rolling over the loan offset amount to a new employer’s 401(k) plan (if permitted by the plan) or to an IRA, as long as this is done by the federal income tax filing deadline, including extensions, for the year in which the offset occurred.

 

3. You’re losing an opportunity to potentially grow your savings and investments

As much as you may need the money now, by taking a withdrawal or borrowing from your retirement account, you’re interrupting the potential for the funds to grow through tax-deferred compounding — and that could make it more difficult for you to reach your retirement goals, Walker notes. Taking funds out of your plan account might mean missing out not only on the potential growth of the money you have invested but also on any growth of that money’s earnings.

 

“As a general rule, dipping into your retirement funds to cover a short-term need could end up costing you more in the long run,” says Walker. “If it’s possible, I’d encourage you to consider other ways to access cash that could be more beneficial to your long- and short-term financial goals.” 

 

 

Alternatives to withdrawing or borrowing from your 401(k) early

“Before you consider taking a loan or a withdrawal from your 401(k), which may be your only retirement savings, make sure you’ve explored other options that could meet your needs,” Walker says. Along with consulting a tax professional, discuss the pros and cons of these other borrowing options with your advisor:

• Home equity loan or line of credit
• Personal loan
• Loan Management Account® from Bank of America (a secured line of credit using securities as collateral)

 

Also, remember the value of having a sufficient emergency fund so that you can avoid borrowing money for short-term needs altogether. Set aside these funds in a separate account so you have the money available — if and when you need it. (For more on protecting your finances from unexpected events, see “Preparing for the big ‘what-ifs’ in your financial life.”)

 

“Your retirement savings should be your last resort,” Walker says. By tapping into this long-term savings during your working years, you could be impacting your future financial security.