A 401(k) plan is a retirement savings account sponsored by an employer. The 401(k) gets its name from the section of the tax code that regulates them. These plans came into being in the 1980’s as the costs of pensions grew. (http://guides.wsj.com/personal-finance/retirement/what-is-a-401k)
While some plans do include an employer match to contributions, the bulk of the monies are from the employee. Contributing is easy because the money is deducted directly from the employees pay.
While the 401(k) savings are earmarked for retirement, employees sometimes turn to these accounts for resources. I have had employees shocked when they are told they can’t just withdraw funds.
“But it is MY money,” I have heard. “I’ll just pay the penalty.” Unfortunately it does not work that way. The IRS governs how these accounts operate and stipulates that, for a current employee, withdrawals can be made only for hardship reasons. They outline the reasons as follows:
- Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care;
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
- Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
- Funeral expenses; or
- Certain expenses relating to the repair of damage to the employee’s principal residence.( http://www.irs.gov/retirement)
Further, the employee must provide proof to the employer plan trustee substantiating the request. There are, of course, additional rules and requirements as defined by the IRS and the employer.
An alternative employees will take advantage of is a 401 (k) loan. Check with your employer for your plans loan specific provisions. Keep in mind, loans must be repaid, with interest.
While the payments do go back into the employees account, the time value of money is lost. Why is that important? Stephen Michaels, Retirement Specialist at SmithBrothers in Glastonbery, CT explains, “Dollar cost averaging is the only way to make money in the long term. Putting money into an investment on a regular basis helps leverage the cost basis and reduce overall volatility.”
In addition, there is a major taxable risk to taking a 401(k) loan. If your employment terminates the loan must be paid back within 60 days or it goes into default. In some cases the taxes and penalties on a defaulted loan can exceed 40% of the original loan amount.
Michaels shared that, in his experience, the reason people turn to their 401(k) for money is they are living above their means. No one wants to hear that, but it is usually the case. “The best financial advice I can give is reduce your expenses.”
For individuals who have no other savings, there are instances when there is an immediate need to borrow from your plan. For example, the furnace breaks or your car needs expensive repairs. Other than those exceptions, stay away from the 401(k) savings.
On a side note, happy 21st birthday to my nephew Daniel. You are officially an adult, start saving for retirement!