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If you need money but are trying to avoid high-interest credit cards or loans, an early withdrawal from your 401(k) plan is a possibility. However, before you consider this option, be forewarned that there are often tax consequences for doing so.

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If you understand the impact it will have on your finances and would like to continue with an early withdrawal, there are two ways to go about it — cashing out or taking a loan. But how do you know which is right for you? And what are the tax consequences you should be expecting?

A 401(k) loan or an early withdrawal?

Retirement accounts, including 401(k) plans, are designed to help people save for retirement. As such, the tax code incentivizes saving by offering tax benefits for contributions and usually penalizing those who withdraw money before the age of 59½.

However, if you really need to access the money, you can often do so with a loan or an early withdrawal from your 401(k) — just remain mindful of the tax implications for doing so.

What is a 401(k) loan?

Most 401(k) plans allow participants to borrow their own money from the plan and repay the loan through automatic payroll deductions.

Unlike personal loans and home equity loans, 401(k) loans are usually easy to get. There's no credit check, and applications are typically short. However, they're like other types of debt in that you must pay interest on the amount you borrow. Your plan's administrator determines the interest rate, but it must be similar to the rate you'd receive when borrowing money from a bank. The good news though is that you are paying interest to your own 401(k) account.

Typically, 401(k) loans must be repaid within five years. That repayment period can be extended if you use the loan to purchase a home.

What is a 401(k) early withdrawal?

Generally, anyone can make an early withdrawal from 401(k) plans at any time and for any reason. However, these distributions typically count as taxable income. If you're under the age of 59½, you typically have to pay a 10% penalty on the amount withdrawn. The IRS does allow some exceptions to the penalty, including:

  • Total and permanent disability.
  • Unreimbursed medical expenses (greater than 7.5% of adjusted gross income).
  • Employee separated from service at age 55 or older (age 50 for most public safety employees) but only from the plan at the job you are leaving.

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Some 401(k) plans allow participants to take hardship distributions while they are still participating in the plan. Each plan sets its own criteria for what constitutes a hardship, but they usually include things like:

  • Medical or funeral expenses
  • Avoiding eviction or foreclosure
  • The cost of repairing damage to the employee's home

Hardship withdrawals don't qualify for an exception to the 10% early withdrawal penalty unless the employee is age 59½ or older or qualifies for one of the exceptions listed above.

Which is right for you?

For many, 401(k) loans are a better option than early withdrawals. After all, as long as you pay the money back during the required time period, you won't have to pay taxes on the amount withdrawn. Plus, the interest you'll pay is added to your own retirement account balance.

However, there are several reasons to think twice before taking out a 401(k) loan.

  • Decreased paycheck. Most 401(k) plans require participants to repay their loans through payroll deductions. When you borrow from your 401(k), your monthly take-home pay will be reduced by the loan amount. If you're already having financial problems, a reduction in your take-home pay could exacerbate your troubles.
  • Missed retirement contributions and employer matching. Some plans don't allow participants to make 401(k) contributions while they have a loan outstanding. If it takes you five years to repay your loan, that could mean five years without saving for retirement. Plus, if your employer matches your contributions, you'll miss out on matching contributions as well.
  • Missed investment returns. While your money is loaned out, it's not invested in the market. You could potentially earn a better rate of return if it was invested in your 401(k) plan.
  • Fees. Many plans charge origination fees and/or quarterly maintenance fees on loans. This can drastically increase the cost of borrowing money from your 401(k).
  • Potential tax consequences. If you leave your job while you have a 401(k) loan outstanding, you have a limited amount of time to repay the loan. You have until the due date for filing your tax return (including extensions) to repay the loan or roll it over into another eligible retirement account.

For example, if you left your job in December of 2021 and had a $2,000 outstanding balance on your loan, you would have until April 18, 2022 (or get an extension for your tax return) to repay $2,000 in full.

  • If you're not able to repay the loan, your employer will treat the unpaid balance as a distribution.
  • Typically, it will be considered taxable income and subject to the 10% early withdrawal penalty.

Ideally, you want to leave your 401(k) alone until retirement. However, if you find yourself in a really tough spot, borrowing from your 401(k) might be a better option than simply cashing out your balance. Just make sure you understand the potential consequences and do what you can to repay the balance quickly so you can start rebuilding your retirement nest egg.

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