Consumer Smarts: Tapping into 401(k) early can have long-term consequences

Over the years, Nancy Powell of Bellingham has periodically dipped into her 401(k) retirement plan before she retired. She took out money to take care of medical debt, and later to pay off credit card bills and a truck loan.

There would have been $50,000 in the plan had she not tapped into it, but Powell felt she had no choice at the time.

Q: Is there a good time to borrow against or withdraw money early from your 401(k) before you retire? And if you must, what's the best strategy?

A: Most financial experts discourage people from tapping into their 401(k) plans and advise doing so only as a last resort.

"You're borrowing against your future," said Chris Lombardo, credit counselor and area director of ClearPoint Financial Solution's Northwest region. "You're borrowing money from your retirement account and you're giving up the interest you would have been earning. Over the long haul, that's going to have a significant impact on your final 401(k) balance."

Do the math

That amount can add up. If you're 30 years old with $20,000 in your 401(k) and a 6 percent rate of return over the next 32 years, your balance at retirement will be $129,068 at age 62, according to the Financial Industry Regulatory Authority.

FINRA recently issued an alert warning investors about the long-term consequences of tapping into 401(k) plans before age 59 1/2.

In the end, Powell felt OK about her decision to take money from her 401(k) because she and her husband had other retirement income to fall back on. They had his severance package and three pensions. But even she advises others not to do it if they can help it.

"If that's all you have, I wouldn't touch it," said Powell, who got debt-management help from ClearPoint.

Cindy Runger Balas, associate vice president and financial consultant with RBC Wealth Management in Seattle, suggests making other changes first if you need money.

"Look at how you're spending," she said.

Make modest adjustments first, such as cutting back on some grocery items, packing lunches or reducing latte consumption.

"If that's not enough, make major life adjustments," Balas said.

Consider getting a second job, going to a one-car household, refinancing your mortgage so that monthly payments are lower, or tapping into a home equity loan.

If you're in a jam, seek financial counseling from a nonprofit counselor, she said.

You're allowed to tap your 401(k) before age 59 1/2 through a loan, a hardship withdrawal or when you change jobs.

About 20 percent of employees eligible for a plan loan have one, and the average outstanding loan balance is approximately $6,300, according to the Profit Sharing/401k Council of America. You're allowed to take a loan of up to $50,000, or 50 percent of the amount you've invested, whichever is smaller, without incurring penalties.

Some people will pay back their loans, but the reality is that many end up repeatedly returning to their 401(k)'s for cash, Lombardo said.

You may consider dipping into your 401(k) if you're in a pinch, such as being at risk of losing your home, having your wages garnished or filing for bankruptcy, but it should be a last resort, Lombardo said.

"Don't act out of desperation," he said. "Look at all the consequences."

The benefits of borrowing from your plan may seem tempting. You pay it back in less than five years, or 10 years if you use it for a down payment on a house. You generally get good interest rate: prime plus 1 or 2 percent. And loan repayment is usually easy through an automatic payroll deduction system.

But the disadvantages are many.

Defaulting on a loan can be costly. If you fail to repay the loan, you will have to pay both regular income taxes and, if you are under age 59 1/2, an additional federal income tax equal to 10 percent of the outstanding balance. If you leave your job or get laid off, the entire loan is generally due within 30 to 60 days.

Also, selling shares from your stock funds when the market is down may force you to sell at a loss, reducing your long-term investment return, according to FINRA. And creditors may go after that money. Your creditors can't touch your 401(k) balance or up to $1 million in your traditional and Roth IRAs, but once you take money out through a loan or a hardship or regular withdrawal, your creditors can go after that.

If you truly need the money, however, it's usually better to borrow from your 401(k) than making a withdrawal.

"Hardship withdrawals" are allowed before age 59 1/2 in a number of limited situations, including to pay certain medical expenses or college tuition, to prevent eviction or foreclosure or cover a down payment on your home. But expect to pay income taxes on the withdrawal, as well as a 10 percent federal penalty.

If you must take out money, the PSCA suggests preserving your asset allocation plan by withdrawing funds from the fixed-income allocation side of your portfolio. If you have half of your money in equities and half in fixed income, and you're borrowing 50 percent of your plan's value, take the funds entirely from the fixed-income side, or the lowest-returning investment option.