6 better options for emergency cash than an early 401(k) withdrawal
We know it can be a struggle when suddenly you need emergency cash for medical expenses, student loans, or crushing consumer debt. The extreme impact of coronavirus on public health and the economy has only compounded some of the more routine challenges of consumer cash flow.
We get it. The money squeeze can be quick and traumatic, especially in a more volatile economy.
That’s why information about an early 401(k) withdrawal is among the most frequently searched items on principal.com. Understandably so, in a world keen on saddling us with debt.
But the sad reality is that if you do it, you could be missing out on crucial long-term growth, says Stanley Poorman, an advice and planning manager for Principal® Advised Services who helps clients on household money matters.
In short, he says, “You’re harming your ability to reach retirement.” More on that in a minute. First, let’s cover your alternatives.
Alternatives for a quick cash infusion that shouldn’t sabotage your future
1. A bank or credit union loan
With a decent credit score you could snag a favorable interest rate, Poorman says. But “favorable” is relative: That still means 8% – 12% because the loan is unsecured. If possible, secure the loan with some type of asset (such as a car already paid for) to lock in a lower rate.
2. Home equity loan
With your home as collateral you get a better interest rate and a longer payback. It’s friendlier for your monthly budget. Beware how fees for appraisals and underwriting can add to the overall loan balance.
3. Home equity line of credit
Instead of fixed-term repayment, you get a variable repayment and interest rate. You may opt for an interest-only repayment, but most often that comes loaded with a balloon payment, Poorman says, and may be tough to afford.
4. Zero-interest credit card
These offers may give you a cushion—but watch the terms: If the card’s interest is “capitalized,” that means once the initial offer expires, you could be on the hook for accrued interest during the offer period. This can dramatically increase your principal balance and make it even harder to eliminate credit-card debt. That’s why it’s important to pay back the balance on deadline if you transfer debt through this kind of offer.
5. Payday loans
This is a drastic last resort. You receive a cash advance based on steady employment but get buried by massive fees.
6. 401(k) loan
Now we’ve reached the point of dipping into your 401(k)—stopping short of a complete withdrawal. On the surface it may seem to make sense to rid yourself of 15% or 16% interest on credit card debt. A 401(k) loan (with a $50,000 max or 50% of account*) technically is a better option because you repay yourself, although it still carries risk: If you leave your job, you must quickly return the full balance, typically within 60 days or be taxed for unpaid balance.
A key change in 2020: As emergency assistance to workers who are sick or out of work due to COVID-19 (or have a sick spouse or dependent), the federal government temporarily gave employers the flexibility to double their maximum possible 401(k) loan limit to $100,000, or 100% of vested account balance—whichever is less. This only applies to loans made for 180 days following the March 27th enactment of CARES and is only for individuals who meet the same COVID-19 related conditions. (Beware: If you default on repayment, you’ll get hit with a 10% penalty.) Also, if you have an existing 401(k) loan, you may be able to delay payments for a year.
A deeper dive on the 401(k) loan option
A loan is more strategic than a withdrawal, which torpedoes your savings altogether. With a full cash-out, instantly you lose a big chunk, paying a 10% penalty to the IRS if you leave the plan under age 55 plus another 20% for federal taxes. For instance, with a $50,000 withdrawal, you may keep just $32,500 (65%) and pay $17,500 (35%) in state and federal taxes. And the leftover sum you receive, if you happen to be in a higher tax bracket, may nudge you into paying even more taxes for that additional annual income.
Another adjustment in 2020 for workers affected by COVID-19: If your plan allows or through your IRA, you can withdraw up to $100,000 without the 10% penalty even if you’re younger than 59½. The standard 20% federal tax withholding does not apply, but 10% withholding will unless you decide otherwise. You also can spread your income tax payments on the withdrawal over three years.
We understand emergencies can leave people with limited choices. Just remember that even the less extreme option of a 401(k) loan may paint your future self into a corner. The most severe impact of a 401(k) loan or withdrawal isn’t the immediate penalties but how it interrupts the power of compound interest to grow your retirement savings.
At the very least, don’t start stacking loans (simultaneously burdening yourself with multiple loans). Some employer retirement plans allow as many as three.
If you’ve already taken a withdrawal or loan, you can recover
Stay calm and make steady progress toward recovery. It can be done. Build up a cushion of at least three to nine months of your income. No matter what incremental amount you save to get there, Poorman says, the key detail is “consistency and regularity.” For instance, have the sum automatically deposited to a savings account so you can’t skip it.
Scale back daily expenses. Keep your compact car with 120,000 miles and drive it less often to your favorite steakhouse or fashion boutique.
Save aggressively to your 401(k) plan as soon as possible and stay on track. Bump up your 401(k) contribution 1% annually, until you maximize your retirement savings. Sock away the money earned from any job promotion or raise.
* Generally, the maximum loan amount is the lesser of (A) or (B): (A) 50% of the vested account balance, reduced by any outstanding loan balance, or (B) $50,000 reduced by the highest outstanding loan balance during the past 12 months. This includes all loans (new loans taken in the past 12 months, loans paid off in the last 12 months, and all defaulted loan balances, no matter how old the loan).
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Investment advisory products offered through Principal Advised Services, LLC. Principal Advised Services is a member of the Principal Financial Group®, Des Moines, IA 50392.
Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Principal Life, and Principal Securities are members of the Principal Financial Group®, Des Moines, Iowa 50392.