Dear Reader: While I don't like to get in the middle of a family disagreement, I have to say that for the most part, your sister is right. The big deal is that by tapping into your 401(k) balance early, you could be hit with significant penalties and taxes. Plus, you run the risk of jeopardizing your future to pay for the present.
I can certainly understand how you might see your 401(k) as a source of cash -- after all, you've saved the money and it's yours. And when times are tough and you have no other options, it may help you get out of a jam. But you need to take a step back and think about why you're saving the money in the first place.
Since your sister is older and presumably closer to retirement, she may be feeling more concerned about having enough money to comfortably retire. And it's a valid concern. For many people, a 401(k) is the most significant savings they have. If you deplete it early, what will you live on come retirement time?
Taking money out of your 401(k) early -- even as a loan -- can have long-term repercussions, so there's more to think about than just your current cash needs.
FIGURE OUT HOW MUCH YOU STAND TO LOSE
Uncle Sam gives you some tax advantages with both a traditional and Roth 401(k). Contributions to a traditional 401(k) lower your taxable income, earnings grow tax-free, and you don't owe income taxes until you make a withdrawal. With a Roth 401(k), you don't get the up-front deduction, but any earnings grow tax-free and withdrawals after age 59 1/2 are tax-free, provided you've held the account for five years.
Those are the basic rules -- all designed to help you save for retirement. However, if you step outside those rules, there are consequences. For instance, take a withdrawal before age 59 1/2 and (with a few exceptions) you'll be slapped with a 10 percent penalty. Not only that, you'll pay income taxes at your ordinary rate unless it's a Roth 401(k).
So let's say you're age 50 and in the 25 percent tax bracket. You've run up some hefty credit card balances and you want to pay them off. You decide to withdraw $20,000 from your traditional 401(k). First, you'd have to subtract the $5,000 you'd owe in income taxes. Then you'd have to subtract an additional $2,000 in penalties. Right away, you're down $7,000 or 35 percent.
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