Accessing Your 401(k) Money

Early Withdrawals from a Regular 401(k) Plan

401(k) plans are designed to provide tax benefits to contributors to be generally used in retirement, since this is after all a retirement plan. Rather than just leave contributors to a 401(k) to their own resources, there are a number of rules surrounding withdrawing from your 401(k) plan that you need to be well aware of, well prior to the need or desire to withdraw from it.

The reason why we need to prepare and account for these rules is that we do not want to be putting money in a 401(k) that we should not, where accounting for the impact of these rules properly would have led to a different decision.

Simply put, taking money out of a 401(k) plan prior to age 59 ½ is generally something that we want to always avoid, and while we cannot anticipate and plan for all of the things that may have us wanting to do this, we do owe it to ourselves to be reasonably aware of why we should keep our money in the 401(k) prior to this age if possible.

We often will cite the 10% penalty that is involved with early withdrawals from a 401(k) as the reason why this should be avoided, but taking money out of a 401(k) prior to retirement isn’t a good idea in itself, and this penalty just adds to the reasons why not.

In addition to paying the 10% up front with an unqualified withdrawal, we also need to declare the amount withdrawn as income, with the penalty being added on as extra tax. For instance, if we withdraw $10,000 from our 401(k), and we’re in a 25% tax bracket, we will pay the normal $2500 in tax plus an extra $1000, and only be left with $6500 to spend.

In comparison, if we left this $10,000 to grow in our 401(k) for another 20 years, at an inflation adjusted return of 3%, we’ll end up with $16,000 in today’s dollars. We’ll need to pay tax on that and if our tax rate remains at 25%, we’ll end up with $12,000 later instead of the $6500 we got from the withdrawal. If our tax rate goes down to 15%, as it will with a lot of people, then the difference is even larger, providing us $13,600 for our retirement, over twice as much as we ended up with when we took out the money.

Early Withdrawals from a Roth 401(k) Plan

Roth 401(k)s also come with a 10% tax penalty when we make an unqualified withdraws, and this is a significant amount that needs to be accounted for properly. We also need to be aware that we won’t receive the tax benefit on the money that was earned in the 401(k), like we would normally with a Roth 401(k), and will be subject to declaring this as ordinary income.

What proportion of the Roth 401(k) withdrawal is considered principal and what proportion is considered to be growth and therefore taxable will depend on our principal to account value ratio. If, for instance, we have put in $100,000 in the account and it is currently worth $150,000, this means that the earnings are .33 of the total sum, or and this is what gets applied to the treatment of the withdrawal.

If we take out $10,000 with an unqualified withdrawal, we will then end up with $3333 of this being taxable income. With a Roth IRA, the 10% early withdrawal penalty only applies to the amount subject to income tax, the $3333 in our case. If our tax bracket is 25% like in the previous example, the effective tax rate is 35% and the total tax due is $2166.

This has us with $7834 in our hands from the $10,000 withdrawal, instead of the $6500 we ended up with when we did the same thing with a regular 401(k). While this does appear to mean that we end up better off when we withdraw from a Roth IRA, we need to keep in mind that the Roth deals with after tax income, and the actual contribution amount we could have made with $10,000 of after-tax money in our tax bracket is actually $13,333.

While we will have to pay tax on this amount, and if our tax bracket doesn’t change, essentially give back this extra $3333, we do get to use it in the account for the time that it is in there and reap additional earning. This added fact makes these two options pretty similar as far as their ultimate impact upon our retirement.

It’s just not a good idea at all to withdrawal from either type of 401(k) prior to age 59 ½, and we also need to be careful to only take it out or move it to something else when we need the money or it makes sense overall to roll it over.

Borrowing from a 401(k) Plan

One of the features that is unique to 401(k) plans, as opposed to IRAs, is the ability to borrow money from your 401(k). Many people see 401(k) loans as considerably better than just making a withdrawal, and it’s generally better to borrow than withdraw if withdrawing it would result in a 10% tax penalty, but this is something that should be avoided as well whenever possible.

We should not be putting so much of our money into our retirement accounts, and especially into a 401(k), that we may expect to need later for purposes other than retirement. People will even overspend and rack up a lot of high interest credit card debt, and then borrow from their 401(k) to pay it down, even though what the money was spent on was highly discretionary.

While we can get ourselves into some spots where, in spite of the issues with 401(k) loans, it can still be wise to take out the loan, but we need to do our best to look to avoid our being placed into such a situation. While this sometimes may not be avoidable, due to situation such as one losing one’s job or a major unexpected expense occurring, often times this happens just with our overspending and also not choosing an appropriate amount to contribute to our 401(k).

We can borrow allowable amounts without any direct tax consequences, and while our ability to borrow from our 401(k) depends on the plan, most employers do offer this ability with their particular plans. We do need to be aware of what we are doing prior to taking out one of these loans, or even better, if we are exposing ourselves to the risk of needing to.

We actually do pay interest on 401(k) loans even though we are borrowing our own money, and are the recipient of these loan payments. This does mean, however, that we are going to not only have to come up with payments to cover the principal of the loan but interest payments as well, and most notably, that we will be replacing the amount borrowed with after-tax money.

Let’s say we borrow $10,000 from our 401(k). We can disregard the interest here as long as we’re able to contribute this extra amount as this is just going into our 401(k) and we can therefore just view this as a separate contribution.

We will need to pay income tax on the money we use as payments, and once it is back in the 401(k), it is still subject to income tax when withdrawn. This results in an odd situation where we become double taxed on our loan repayments, which is certainly not a desirable fate.

This is something that the IRS could perhaps fix by allowing us to make these loan payments pre-tax, but presently that is not the case, and this certainly should give us plenty of pause for thought when we are considering borrowing from our 401(k). Instead, people liberally take out these loans and about a quarter of all participants have one out at any given time.

If we take a loan out for $10,000 and repay it, we are still left with paying the tax owing on this amount when eventually withdrawn. Let’s say we have to earn 13,333 to net $10,000 after taxes. If we use this money to repay a 401(k) loan, with the same tax bracket, we end up paying another $2500 in tax, and only end up with $7500 from this income of $13,333, which is simply way too much tax to pay for this bracket.

Therefore, like 401(k) withdrawals, 401(k) loans should only be used when truly necessary, and we should take reasonable steps to avoid either of these things at all.

Qualified Withdrawals with 401(k) Plans

After the age of 59 ½, or earlier if an exception is granted, we can take money out of our 401(k) plans without penalty. This does not mean that we should do so though, because there’s more at stake here than just not paying an additional 10% in taxes.

401(k) accounts are set up to help us in retirement and their structure demands that we do use them for retirement if we’re going to get the most out of them. While we’re still working, and especially while our employers are still matching our contributions, it is very important that we be putting money into these accounts and not taking money out.

We do need to carefully determine how much we can put into our 401(k)s, and not be overly aggressive with our contributions. We can actually use Roth IRAs to hold money that we are not so sure about, because we can withdraw the principal from these accounts with no penalties or tax implications.

While we don’t want to throw money into any tax-sheltered account that will likely be needed to be withdrawn early, if we’re going to make a mistake with this, it’s better to make one that does not involve paying a price for beyond having used the contribution room.

When it comes to accessing our 401(k) money in retirement, we should look to get whatever we can out of it that does not increase our tax rate, and amounts that are not needed for day-to-day spending should be rolled over into a Roth IRA. We do need to be aware of the limits here though and the fact that the account needs to be held for a minimum of 5 years to make qualified withdrawals from it, although this can all be set up in advance so that this becomes a non-issue.

Rolling our 401(k) money into a Roth IRA will require us to pay tax on amounts rolled over, but this tax will need to be paid some time and we just need to make sure that we’re not paying a higher rate now than we would later. Having the excess money in a Roth IRA will allow us to enjoy tax benefits from its growth without subjecting either the principal or the earnings to further taxation.

Like traditional IRAs, once we reach the age of 70 ½, both regular 401(k) accounts and Roth 401(k)s require us to make prescribed withdrawals every year. The amount we have to take out is based upon the size of the account and our life expectancy, although money in a Roth IRA is not subject to this requirement.

401(k) accounts are a great way to save up for retirement and make it very worthwhile for us to do so, where we actually receive significantly more value from our money saving it this way versus what we could get out of it now.

If we play our cards right, we can really help ourselves in our final years, but only if we manage to set aside enough and have the discipline to stay the course and keep this money for retirement only whenever possible.