Raiding Your 401(k) Can Be Taxing

If you’re finding it hard to pay your mortgage or reduce your credit card debt, you could be tempted to tap your 401(k) retirement savings.

Many 401(k) plans allow workers to borrow against their savings and, in effect, pay themselves back with interest within five years. A study by the nonprofit Transamerica Center for Retirement Studies found that employees taking loans from their plans jumped to 18 percent in 2007, from 11 percent in 2006.

Unfortunately, raiding your 401(k) will not only put a big dent in your retirement savings for the long term, it could cause you considerable tax pain in the short run.

Here’s why.

Say you have some pressing bills, so you take out a $10,000 loan from your $20,000 401(k). True, you won’t be adding to your retirement savings, but at least you’ve got some breathing room, and you’ll replenish your account within five years. At least that’s the plan.

Now let’s say that because the economy is slowing, you get laid off from your job. Most company plans require you to repay your 401(k) loan, typically within 60 days from your layoff – or your loan will become a “distribution.”

In tax parlance, that means that the IRS now considers your loan to be income, like your wages, and you have to pay taxes on it. So, even though you’ve probably spent the loan and you have no job, you owe taxes. If you’re in the 28 percent tax bracket, you could owe $2,800. And if you’re under age 59 1/2, you’ll also get dinged with a 10 percent penalty, or another $1,000.

For more information on the tax downsides of 401(k) loans, read Tax Consequences When You Have a 401(k) Loan and Lose Your Job.

Many 401(k) plans also permit participants to take what are known as “hardship distributions,” for such immediate financial needs as preventing a home foreclosure or paying for a burial. The money is withdrawn and not repaid.

You might expect from the description that taking money from your 401(k) in this manner would involve some financial mercy.

Nope. The same income taxes and penalty apply. You’re facing a big tax bill and the likelihood that it could take years to replenish your retirement savings.

For more information on hardship withdrawals, read Withdrawing Money From Your 401(k) Plan As a Hardship Distribution.

Why do retirement plans let workers sabotage their savings this way? Financial experts theorize that if the plans didn’t allow for some kind of withdrawals, not many people would use them. Let’s hope that despite current tough times, few are tempted.

Comments

[scooter verzekeringen]

I agree this is really interesting and helpful report, provided data explained in this report is reliable and true.

[Russ]

Assuming you don't leave the company (quit, get layed off, etc) during the term of a 401(k) loan, are there any other drawbacks to doing this? Other than missing out on potential appreciation of the loaned funds, of course.

[grace vasile]

HI I AM 49 YRS OLD AND BECAME DISABLED. I TOOK MY 401K AND WAS NOT PENALIZED BECAUSE I WAS DISABLED. I NEEDED IT TO LIVE ON WHILE AWAITING THE FIRST SSDI CHECK. WILL I STILL HAVE TO PAY THE PENALTY FOR BEING UNDER 59 AND A HALF?

[Kevin]

I took money out of my 401k in 2008. Which Turbo Tax product would i use to file my tax returns for 2008?

I took money out of my 401k in 2008. Which Turbo Tax product would i use to file my tax returns for 2008?

[melissa haberman]

I am the benificiary of my exhusbands 401k. I have filled out all the paper work to recieve the distribution with out having taxes taken out. I would like to give the money to my children as a gift. Will I still get hit hard on taxes?

[Sunil]

I have contribution about $8000 in 401k for 2008. How much more I can put in a new IRA account for 2008. I want to save more for retirement. I am 48 years old.

Sunil

[Dorothy Katz]

I am in my second year of the State of Florida government DROP plan with 3 yrs 9 mos to go. Low interest rates and Senate proposed regulation makes me feel I need to cash out what I can of my deferred comp before I lose it. I'm assuming no penality since I am 61 but what percentage of tax would I have to pay and is this a good decision?

[TurboTaxLee]

Hi Charlie,

The 2008 max contribution for a 401(k) for 2008 is $15,500 and for 2009 it will be $16,500. The over 50 catch up for 2008 is an additional $5,000 and for 2009 it will be $5,500.

[Tom, the happy borrower]

I did borrow against my 401k and was very glad I did! I borrowed the max, 50K, and paid off the mortgage on my house last year. So now my 401k just got reduced by about 60%. If I had that extra 50k still in the plan it would have also lost the 60% so I saved $30,000! Best thing I could have done.

[Charlie]

What is the 2008 max allowable contrbution to my 401K plan.
Also how much is the over 50 catch-up for 2008?

[TurboTaxLee]

Hi Glenna, Sorry to hear about your medical bills. If you take money out of your 401k to pay the bills (assuming not a loan), the amount will be taxable. If you're under 59 1/2, you may have to pay an additional 10% penalty (10% of amount withdrawn). However you won't have to pay the 10% penalty on the amount you paid on unreimbursed medical less 7.5% of your AGI that year. The AGI is the bottom line on page 1 of your Form 1040.

[TurboTaxLee]

Hi ed davis, We at Intuit can't give financial advice. However we can give you the pros and cons of loans versus distributions. If you plan to take the distribution, be sure to run a tax calculator to see how much more tax you'll be paying. Check out our 2008 tax estimator http://turbotax.intuit.com/tax-tools/
Be sure to choose 2008 in the drop down list.

Also it's always good to read your 401k plan or check with the 401k person at your workplace to be sure there are no unexpected issues with loans and/or distributions.

[jfmitch]

Beside taking my MDR distribution,I am considering rolling over all my remaining 401k type retirment plans to a Roth IRA plan, considering the reduction in the value of my IRA plans.

Comments ?

Joe Mitchell

[Dana]

Questions, are these being answered? How are they accessed.

[Harold]

I am retired 63 years old did take the SS at 62.
I closed my 401 savings out this year about $150k

I life overseas now for more than 12 years.

Do i have to report this since i am not a resident in any state, but have a foreign residency.
If not how much do i have to pay.
Can i use the the rule of i believe is 80K deductions for overseas residency.

Please advice.

Thanks Harold

[Phil Ratterman]

Question.
Because the market is so low are there any provisions to put off taking money from you SEP or IRA this year?

[Neal Gielstra]

I have a 457 (catchup plan) with the South Carolina State Retirement System wich was (miss)handled by Citi Group and now by ING.The value is decreasing rapidly.I am 69 y old and retired will I get hit by Taxes/Penalty if I decide to cash it out before none is left ?

[john jeisen]

I have a IRA I would like to tap into. I am 69 and will be required to tap into it next year. Will doing it this year spreed the income tax burden over more years and be better for me in the long run. I would like the money to make a vacation cabin purchasre.

[Glenna Faulkner]

We have had a lot of medical bills this year, and will be having bills from 2 more surgeries before the end of the year. If we take money out of our 401K for medical bills, will we be penalized, and count the funds as income?

[E-Jo]

Any news on temporary relief to the RMDs this year? (On the basis of forcing us over 70.5ers to sell 401k stocks in this bad economy is not helpful.)
Thanks,
E-Jo

[ed davis]

I am 61 and plan to retire in three years. I will need to take out $25,000 dollars to help make my payments,now and the next thre years. Should I borrow that money from my 401 k or just get it outright and pay the taxes.
Thanks,

[TurboTaxLee]

Hi Steve & Sandy, Prior to 2008, you could not rollover monies from your 401K plan to a Roth IRA. You could rollover those dollars to another benefit plan or IRA. Does this answer your question?

[Steve & Sandy Cox]

In 2006, we withdrew $32,500 from our 401K, used $15,000 to invest in a Profund, $10,000 to rollover into our Roth IRA's, now we owe taxes on the $10,000. Why?