Should you dip into your 401(k)?

Follow 5 rules to secure financial future

With unemployment having reached a 25-year high in the United States recently, millions of Americans are dealing with financial troubles that seemed unimaginable just a few years ago.

One source of income that people strapped for cash can turn to is their 401(k) accounts. Workers currently employed and those that have lost their jobs have multiple options for dipping into their 401(k) accounts, but there are penalties involved, and financial experts caution this should be done only if it is absolutely necessary.

“I tell people, ‘First, it’s a last resort.’ See if you can get a personal loan, or take a home equity line of credit,” said Nicole Middendorf, a financial planner with Strategic Financial in Plymouth, Minn. “Cut back your expenses. Do something. I always say it’s the ultimate last resort, to take money out of your 401(k).”

But with the economy bringing news daily of layoffs and home foreclosures, many Americans are finding themselves in a crunch if they are struggling to make mortgage payments, pay medical bills or just simply put food on the table.

So, if you must dip into your 401(k) account, you have several options.

Laid Off?

According to Middendorf, laid-off employees who have been paying into a 401(k) account have multiple options surrounding their retirement fund.

The first option is to just leave the money where it is, as you are usually still allowed to keep the account even if you no longer work at the company.

The second option is to roll the money into a traditional IRA account, which is called a conversion. This is what many financial planners recommend. A traditional IRA allows you to convert the money over without having to take a hit and pay taxes, but it is a personal account with contributions you make yourself and is not matched by your employer.

You can roll the money into a Roth IRA, but you must pay state and federal taxes and a 10 percent fee, but the money is not taxed when it is withdrawn prematurely.

You can cash out the account, which is called a distribution, but you must also pay the applicable taxes and fees.

Pros, Cons Of Distribution

When taking a distribution, the tax hit is significant and will typically add up to more than 40 percent of the total.

For the tax year 2008, if you made between $32,550 and $78,850, you must pay 25 percent to the IRS. The next cutoff is $164,550, which pays 28 percent, and the next cutoff of $357,700, which pays 33 percent. Anyone earning over $357,700 pays 35 percent.

So, with a federal tax of about 25 percent to 35 percent, plus a state tax of between 6 and 8 percent, plus the 10 percent fee for cashing out the account before you are 59.5 years old, someone taking a distribution on a $100,000 401(k) account would pay around $41,000 to $51,000 in taxes and penalties.

This is why, according to Middendorf, rolling the money into a traditional IRA is probably the best option, because unless you really need the money you can hold onto the account without taking a tax hit. If things gets worse, and you do need to take a distribution, you still have that option.

“Most people quit a job and they have $5,000 or $10,000, and then they liquidate it. That’s not what you want to do,” said Middendorf. “You’ve got 10 grand in there. After you pay the tax, you’re getting $6,000. Woo hoo! You just blew four grand. So, it’s not the best thing.”

Take A Loan

Each 401(k) is different, but most allow you to take out a loan against the money without having to pay taxes on the funds, as long as you are still employed at the company.

The interest on the loan is typically comparable to a personal loan from a bank, and you are allowed to take out up to half of what is in the account. But there is a significant risk involved if you lose your job or quit before you pay it back.

“If you are let go or laid off, it’s classified as a distribution, and then you have to pay taxes — state and federal taxes — plus you have to pay a 10 percent penalty if you are under the age of 59.5,” said Middendorf.

The loan will not operate much differently than a personal loan, so Middendorf also recommends pursuing a personal loan and other financial options first.

“People say, ‘Oh, I’m just taking a loan from myself.’ Well, you’re really not,” said Middendorf. “You’re better off generally cutting off expenses and doing other things rather than really using retirement assets for living expenses now.”