Raiding A 401(k)? Brace For Taxes, 10% Penalty

By EILEEN ALT POWELL The Associated Press

Published: Feb 20, 2008

Although 401(k) and other employer-sponsored retirement accounts are for long-term saving, many of the plans allow early withdrawals under special circumstances. But under tax laws, there can be consequences if people withdraw from their accounts before age 59 1/2 :

Do a lot of people tap their 401(k)s?

In recent years, 18 percent of plan participants have taken loans against their accounts, say studies by the Investment Company Institute and Employee Benefit Research Institute. The average unpaid balance at the end of 2006 was just less than $7,300, the Washington-based groups said.

Is it such a bad idea?

"This should be the very last resort," said David Wray, president of the ProfitSharing/401(k) Council of America in Chicago. "This is your long-term savings, and you interrupt both your savings and your earnings when you make withdrawals."

What are the penalties for cashing out the entire account?

Because these accounts are funded with pretax money, they become taxable when money is withdrawn. If workers are younger than 59 1/2 , the amount of the withdrawal also can be subject to a 10 percent penalty. So if those workers are in a 25 percent federal tax bracket, they could lose 35 percent of the money to taxes and penalties.

So a loan is better?

Definitely. You can borrow $50,000, or half of the vested balance in the account, whichever is lower. The worker must pay the loan back, usually within five years, with interest generally set close to what a bank would charge, it said.

Generally, loans are paid with paycheck deductions. The worker can continue to contribute to the plan, but many find it necessary to cut back until the loan is repaid. If they cut back too much, they may miss out on some of an employer's matching money. The worker also misses out on the earnings on the money that's withdrawn.

Further downside: If an employee defaults or leaves a job without paying back all of the loan, the outstanding balance is taxable and the 10 percent penalty can apply, tax lawyers say.

But what if it's an emergency?

If someone wants a hardship distribution, an employer first will ask the worker to take a loan for half of the account balance, Wray said.

Most companies limit emergency withdrawals to categories approved by the Internal Revenue Service: medical expenses, purchase of a principal residence, to prevent foreclosure or eviction, repair of storm damage, payment of tuition, and payment of funeral expenses.