Do think twice: It's not all right to tap your 401K

There have been reports that many cash-strapped Americans are making some classic financial mistakes these days as they try to cope with rising prices at the gas pump and grocery store and sinking values in their homes. They are the classic mistakes that many investors make when they panic: thinking about the moment rather than the future, and going with their gut -- which may be churning with stress.

Mary Schapiro, CEO of the Financial Industry Regulatory Authority (FINRA) issued a warning last week, saying that Americans are faced with a "perfect financial storm," with rising costs of food and gas, a credit crunch, and a weakening job market. And they are tempted to use risky ways to make ends meet, said Schapiro. These include tapping their 401(K)s or cashing in life insurance policies.

Those strategies should only be considered as a last resort, as Schapiro emphasized. Investors could be risking their financial futures and a secure retirement as they try to cope with tough times. FINRA warns sternly against using your 401(K) to get through a rough patch. For one thing, if you are under age 59-1/2, you'll be paying taxes through the nose: You'll have to fork over ordinary income tax on the amount you withdraw, plus a 10% penalty tax. To increase the pain, some employers will withhold 20% of your withdrawal amount. Which means that instead of getting the $20,000 you were hoping to use to pay the bills, you could wind up getting less than $14,000.

However, the biggest price you'll pay will be losing the opportunity to increase your investment in the future. Let's say that you're 40 years of age, and you have $40,000 in your 401(K). If it's growing at a conservative rate of 6%, you'd have more than $107,000 in 17 years, and that's even without adding more contributions. But if you withdraw half of your $40,000, the remaining $20,000 would be worth less than $54,000 in that same period of time. That's a dead loss of more than $50,000 just to get that $14,000 for your current needs. Think about it.

Here's what else you'll be losing if you stop contributing to your 401(K) and start withdrawing instead. Contributions to your 401(K) reduce your taxable income, thereby lowering your tax bill. And you'll be losing the amount that your employer would be adding to match a percentage of your contribution. OUCH!!
And did you know that if you take money out of your 401(K), creditors can come after it? They can't touch your retirement savings account, thanks to the Bankruptcy Abuse Protection and Consumer Protection Act. (You're protected up to $1 million.) But they can try to grab the money you've withdrawn from your retirement savings accounts, even if it's just a loan or a hardship withdrawal. That means you could lose ALL of the money you've withdrawn from your 401(K) if things go wrong.

Maybe it's best to think of your 401(K) as your health insurance for the future. If things look difficult now, imagine what it will be like when you're older and retired and have no way to increase your income. That extra $50,000 will probably make even more of a difference to you when you're living on a fixed income than the emergency money you need now.

From the Community…

Comments 1-4 of 4

Posted by Steve Sun Jul 6, 2008 5:53pm PDT

Why oh why is every article written to a third grade level of financial intelligence? oCan we have something with a point of view and insights beyond the blazingly obvious? Its no wonder there are so few comments when little useful information is ever included in these articles.

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Posted by C. F. Chapman, womanwithportfolio.com Mon Jul 7, 2008 3:31pm PDT

Steve's comment is the reason we need Web sites like Shine, to avoid the kind of macho blowhards who bloviate anonymously on numerous male-dominated financial sites.

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Posted by fools_and_sages Tue Jul 8, 2008 7:53am PDT

I love the fact that the assumption is that everybody has a six figure 401K. A lot of people don't have that.
I'm in my 30s. Two years ago I finally got a job that offered a 401k. I am also fully vested in the 401k at my current job because they took the 5 years of part-time work I did for the company into consideration when they promoted me to full-time. However, my current job pays so little, I make the minimal contribution it takes to get employee matching contributions to the 401k account.
I just finished grad school and just got a new job that will pay me twice as much as I make now and I'm using my 401k funds from my current job to pay for relocation since the new job won't completely pay for that. Since I'm fully vested, there is no penalty for early withdrawal with my employer. The total "hit" I'll take for withdrawing it now will be about 17% for the taxes. . or a whopping $650. And the tax deduction I'll get for relocation costs will get me much of that "hit" back.
So, it's not a big deal when you don't have a six figure 401k.

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Posted by C. F. Chapman, womanwithportfolio.com Tue Jul 8, 2008 12:40pm PDT

Sounds like you made a sensible decision, after weighing your alternatives, as long as you start up your 401(K) again. Everyone has to start somewhere to eventually get that six-figure 401(K). Fortunately, you're young enough to build a nice nest egg. It gets harder and harder when you start later in life.

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