I’ve Fallen on Hard Times. Can I Cash Out My 401(k)?

Should you cash out your 401(k)? It's a question that might cross your mind when you need cash, and you have the option of a 401(k) withdrawal. From losing your job to facing sudden medical debt, many financial situations can suddenly make it difficult to pay your bills.

Before tapping into your retirement fund, make sure you understand the effects on your current financial situation and your retirement years.

You can usually make an early 401(k) withdrawal, but it can cost you a lot of money. This option is best used as a last resort because options like a personal loan are usually more affordable in the long run. Some employers don't allow you to make early withdrawals from your 401(k). Ask the HR department about your company's policy on early withdrawals if you're considering this option.

What Does Early Withdrawal Mean?

An early 401(k) withdrawal means you take money out of the retirement account before the age of 59 and a half. This typically results in a 10% penalty for the early withdrawal, plus income taxes being charged on the amount you withdraw. You can lose a large chunk of your retirement fund to the penalties and taxes.

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What Is a Hardship Withdrawal?

A hardship withdrawal allows you to make an early withdrawal if you're facing an "immediate and heavy financial need," according to the IRS. Employers aren't required to offer this option, but your employer can determine if your situation qualifies with help from IRS guidelines if they do offer it. Examples of situations that might qualify you for a hardship withdrawal include medical expenses, tuition or educational expenses, funeral expenses for family members or beneficiaries, buying a home or and making payments to help you avoid eviction or foreclosure.

You'll still pay income taxes on the amount you withdraw, regardless of the reason for needing the money. You might not have to pay the penalty, though. The reason for the hardship withdrawal determines if you pay the 10% penalty. You typically pay the penalty if you use the money for your home purchase, tuition or funeral expenses or to avoid foreclosure or eviction. Make sure you understand whether you'll pay the penalty before you take a hardship withdrawal.

What About a 401(k) Loan?

A 401(k) loan is an alternative to withdrawing the money. You're essentially borrowing money from yourself through your 401(k) savings with the intent to pay it back into the account. Just like early withdrawals, 401(k) loans aren't always available from your employer. If your employer offers these loans, you'll likely have your payments deducted from your paycheck each pay period to replace the money you borrowed on a set schedule.

A 401(k) loan has several benefits in certain situations, including:

• No taxation if you pay it back on schedule
• Usually no effect on your credit score
• Automatic payments from your paycheck to avoid late fees or default
• Quick funding, sometimes only taking a few days
• Typically no prepayment penalties if you pay it back faster than planned
• No significant loss of retirement funds because you're putting it back into your account

If your financial hardship is temporary and you can afford to make the 401(k) loan payments, this could be a good alternative to a traditional withdrawal. However, your paychecks going forward will be lower due to the loan payments, which can strain your finances more if you can't get things back on track.

If you leave your job or get fired before you repay the loan, you'll have to repay the remaining loan amount when you separate from the company. If you don't, it becomes taxable and subject to the 10% penalty if you're under 59 and a half years old. Consider how long you plan to stay at the job before taking a 401(k) loan to avoid this situation.

Note that there are limits on 401(k) loans, so borrowing the full amount isn’t going to be an option. Per the IRS, loan limits are restricted to either $10,000 or 50% of your vested value, whichever is greater, with a total cap of $50,000. This means that if you have $30,000 vested, you can borrow up to $15,000 without issue, but if you have $150,000 vested, you can only borrow up to $50,000, as 50% of the vested balance exceeds the cap.

How Will These Options Impact My Retirement Savings?

An early withdrawal can drastically reduce your retirement account balance depending on how much you take. Because you'll pay the penalty and taxes from the amount, you'll likely need to withdraw more than just the amount of money you need, which can drain your account even more. If you're close to retirement age, you don't have as long to make up for this decrease in your retirement savings. A 401(k) loan doesn't have as much of an impact because you'll pay the loan back.

Alternatives to a 401(k) Withdrawal

Taking an early 401(k) withdrawal might seem like the easy solution, but it comes at a high cost. Explore alternatives before you dip into your retirement savings. Compare the costs and long-term effects of each option before deciding.

• Borrowing money from friends or family
• Taking out a personal loan
• Getting a home equity loan or line of credit
• Refinancing your home and cashing out your equity
• Using a low-interest credit card
• Selling a vehicle or other high-ticket item you don't need
• Working overtime, getting a second job or taking odd jobs on the side
• Stopping your 401(k) contributions temporarily to have larger paychecks
• Cutting extra expenses
• Working with lenders and service providers to work out a payment plan or hardship deferment to avoid falling behind or defaulting
• Withdrawing money from a Roth IRA, which has more flexibility than a 401(k) — typically requiring no penalties or income tax to withdraw your contributions early

A 401(k) withdrawal or loan could be the only option for your situation. Work with a financial adviser to make sure you fully understand the financial impact before going forward with it.