Americans saving for retirement would be wise to consider risks involved with their 401(k) money — and bestselling personal finance author Dave Ramsey warns Americans to watch out for big mistakes to avoid.
Among the pitfalls people often encounter is the desire to take money out of their retirement accounts.
“When life happens, it’s tempting to turn to the savings stashed in your 401(k),” Ramsey wrote on Ramsey Solutions. “The money’s just sitting there, right? Turns out, withdrawing money from your 401(k) early is like one of those awkward social media relationship statuses — it’s complicated.”
The Internal Revenue Service (IRS) explains penalties involved with such decisions.
“Generally, the amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called ‘early’ or ‘premature’ distributions,” wrote the IRS. “Individuals must pay an additional 10% early withdrawal tax unless an exception applies.”
Regarding the complications Ramsey references, he mentions what he calls a “loophole.”
“401(k) loans allow you to use your retirement savings without paying penalties or taxes as long as you pay the money back,” he wrote. “Of course, doing this comes with a bunch of rules, and things can go really wrong, really fast.”
Escaping 401(k) early withdrawal penalties with a loan
“There are several important tax benefits related to retirement savings accounts, but there are certain restrictions associated with them as well,” wrote Ashley Akin, CPA and senior contributor for TMGM, in an email to TheStreet.
“There may be taxes and penalties for early withdrawal from such accounts, and that is why individuals need to know about the possible risks first.”
There may be taxes and penalties for early withdrawal from such accounts, and that is why individuals need to know about the possible risks first.”
Americans grappling with retirement savings and suddenly facing big expenses might be curious about how to use their 401(k) money without those risks.
It’s possible with a loan, but doing that requires discipline, Ramsey explains.
“A 401(k) loan lets you borrow money from your employer-sponsored retirement account with the understanding that you’ll need to return that money to your 401(k) over time (plus interest),” Ramsey wrote. “If you want to borrow money from your 401(k), you’ll need to apply for a 401(k) loan through your plan provider.”
Ramsey adds a word of encouragement.
“Since you’re technically borrowing your own money, most 401(k) loans get approved without much hassle and have relatively low interest rates,” he wrote. “And because no banks or lenders are involved, nobody’s going to check your credit score.”
“Most plans will let you set up automatic repayments through payroll deductions, which means you’ll be seeing less money in your paycheck until the loan is paid off,” he added. “Those payments — which include principal and interest — will keep going back into your 401(k) until the loan is paid off.”
401(k) loan rules and risks
Here are rules associated with taking out a loan on your 401(k), according to Ramsey.
- Borrowing limit: You can typically borrow up to $50,000 or 50% of your vested account balance, whichever amount is less.
- Repayment: The maximum period allowed to fully repay the loan is five years.
- Interest: You must pay interest on the borrowed funds, but those payments go directly back into your own 401(k) account.
- Credit check: No credit check is required when you take out a loan against your 401(k).
- Job loss risk: Leaving your job with an outstanding loan balance requires you to repay the full amount quickly, or the remaining sum will be subject to income taxes and early withdrawal penalties.
(Source: Ramsey Solutions)
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Vanguard clarifies 401(k) early withdrawal penalties
Using money that one has earmarked for retirement in a 401(k) account without procuring a loan does involve penalties.
“For example, if you withdraw $10,000, you could be looking at total taxes and penalties of $3,200 (if you’re in the 22% tax bracket) — leaving you with $6,800 to deal with your emergency,” Vanguard explains. “And that might not even be the worst part.”
More on personal finance:
- Charles Schwab, Fidelity alert workers to forced 401(k) rule
- Dave Ramsey warns Americans on 401(k)s, IRAs (he’s not wrong)
- Congress research arm warns Americans on 401(k), IRA penalty
Vanguard couches this in terms of achieving one’s retirement savings goals.
“Going back to our example, $10,000 might seem like a small drop in your retirement bucket, but you’ll also miss out on years of compounding,” Vanguard wrote. “That means your balance could be up to $57,000 less than if you hadn’t made the withdrawal.”
And Vanguard adds a warning about 401(k) loans.
“What about taking a loan from your 401(k) instead?” Vanguard asks. “Remember that if you fail to pay back the loan — or if you leave your employer and can’t repay the loan immediately — you’ll face the same taxes and penalties that come with a withdrawal.”
Related: Fidelity warns American workers on 401(k), IRA mistakes
