By Emily Brandon
Many people dip into their 401(k)s before retirement when they change jobs or experience a financial emergency. Workers who take early withdrawals from their retirement accounts often never replace the money and end up with significantly less cash in retirement. A recent Center for Retirement Research at Boston College report found that leakages reduce retirement wealth by about 25 percent. Here's how money leaks out of retirement accounts and what you can do to prevent it.
Hardship withdrawals from 401(k)s are often permitted when the worker can demonstrate an "immediate and heavy financial need" for the money, which might include medical care, higher education costs or repairing or avoiding foreclosure on a home. But hardship withdrawals are expensive, typically resulting in a 10 percent early withdrawal penalty for people under age 59½ and 20 percent withholding for income taxes. And employees who take hardship distributions are prohibited from making new contributions to the 401(k) plan for at least six months, which means they miss out on the tax break and employer match going forward. Maintaining an emergency fund outside of your retirement account can help you to avoid the taxes and penalties of an early 401(k) withdrawal.
When they change jobs, employees are able to take lump-sum distributions from their retirement accounts. These distributions are also subject to the 10 percent early withdrawal penalty (if the worker is under age 55) and 20 percent withholding for income tax. Workers who don't need the money immediately can preserve their assets and avoid the taxes and penalties by rolling the balance over to an individual retirement account or new employer's 401(k) plan. The money can also be left in a former employer's 401(k) plan if the balance exceeds $5,000. Balances between $1,000 and $5,000 might be automatically transferred to an IRA in the absence of employee instructions, and balances under $1,000 could be automatically cashed out if the account owner doesn't select another option.
Loans are typically the least damaging way to access your retirement savings early, because the money is typically repaid with interest and isn't taxable. Most 401(k) participants are permitted to borrow as much as 50 percent of their 401(k) account balance up to $50,000. The loan typically must be paid back within 5 years. "Most borrowers continue to contribute to the plan while they have a loan, and most of the money is repaid," according to the Center for Retirement Research report. "The likely point of default arises when a terminating employee cannot repay the loan within 60 days, causing the money to be treated as a taxable distribution and subject to penalties." These loans typically have origination, administration and maintenance fees, and if you lose or leave your job, the loan suddenly becomes due. Loans that aren't repaid on time are considered distributions and become subject to income tax and, for people under age 59½, the early withdrawal penalty.
Regularly contributing to a retirement account over many years is a solid way to build wealth. Retirement accounts typically offer tax breaks, employer contributions and the opportunity for investment growth. But the many benefits of 401(k) contributions are negated when you withdraw money from these accounts before retirement, because you're likely to incur tax penalties and fees and miss out on valuable investment gains.
By Emily Brandon