For many millennials, a workplace 401(k) plan is their first venture into building a significant savings stash. According to Fidelity Investments, 401(k) savers age 20 to 29 whose plans are managed by the firm have an average balance of $12,200, and those 30 to 39 have an average of $43,400. But not all young employees leave the money untouched. One in four adults age 18 to 34 with a 401(k) have already made a withdrawal or borrowed against the account, according to a study from Merrill Lynch and Age Wave. The primary reason: Paying credit card debt.
When debt looms or a surprise expense arises, your 401(k) balance may look like the perfect solution. But you shouldn't tap your 401(k) until you've exhausted other sources of funds. The more you tuck away--and keep--in retirement accounts when you're young, the more you'll benefit from compounding investment returns over time.
Fidelity's research also reveals that among survey respondents who had a financial emergency within the past two years and did not have an emergency fund, 42% took a loan or withdrawal from their retirement plan. Work on socking away at least three to six months' worth of living expenses in a no-fee, high-yield savings account.
The 401(k) loan. If you can't come up with any other sources of cash, taking money from your 401(k) as a loan instead of a withdrawal will minimize the harm to your retirement security. You can generally borrow up to 50% of your vested account balance or $50,000, whichever is less. Or, if half of the vested balance is less than $10,000, you may still be able to borrow up to $10,000 of your total balance, if your employer allows it. Instead of forking over principal and interest to a lender, you pay it back to your own retirement account. Often, interest is the prime rate plus one percentage point, which recently added up to 6%. With the average credit card interest rate at about 17%, paying off card debt with a 401(k) loan can make sense.
Taking a 401(k) loan once and paying it back in full typically has little impact on retirement security, says Eliza Badeau, Fidelity's director of workplace investing thought leadership. The trouble, says Badeau, comes when employees take out multiple loans and stop or decrease contributions. To keep your savings on track, try to contribute at least enough to your 401(k) to capture any employer match, in addition to your loan payments. And take a hard look at why you needed to borrow in the first place. If you struggle to control your spending, you're at risk of continually relying on your 401(k) for backup.
Generally, you have five years to repay the loan, and you must make payments at least quarterly. If you don't, the outstanding balance is subject to income tax and a 10% early-distribution penalty. And if you change jobs, you have to pay off the loan by the tax-return deadline for the year you leave your job (including extensions) to avoid taxes and penalties on the balance.
If your situation is truly dire and you can't afford to repay a loan, your employer may allow a hardship distribution. These are typically permitted for specific circumstances, such as medical expenses. Once you take a hardship withdrawal, you can't put the money back, and you'll typically owe income taxes and the early-distribution penalty.
If you leave your job, you can cash out your 401(k) for any reason, and a striking 40% of workers younger than 30 do just that, according to Fidelity. Such distributions trigger taxes and penalties, and pulling the money from the stock market diminishes its earning power. When my status with Kiplinger went from employee to self-employed contractor five years ago, I could no longer contribute to my 401(k), and I decided to let it sit. Since then, the balance has grown by more than $16,000.
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