Is it ever OK to dip into your 401(k) before retirement?
The campaign for Tim Walz, governor of Minnesota and the Democratic Party’s candidate for vice president, confirmed to the Wall Street Journal that Walz made a $135,000 early withdrawal from a 401(k)-type plan last year, but the campaign declined to further comment on his finances. Walz has accumulated pensions as a teacher, a member of the Army National Guard and an elected official — retirement income not typically available to Americans working in the private sector. However, millions of Americans do have access to retirement and pension plans.
Walz and his wife, Gwen, may have been able to afford such a withdrawal: Their 401(k) or equivalent balance — assuming that as a public-school educators, they might have 403(b) plans — likely totals $1 million, based on estimates carried out by the Wall Street Journal. The early withdrawal likely accounted for 10% of their total retirement fund. Although that 10% will never grow again, it was invested in the education of their daughter, according to the campaign. (The Walz campaign did not immediately return a request for comment.)
For anyone who may be thinking about doing the same, here’s some advice: Don’t, if at all possible. “You can’t say never, but in general I think that it is a very bad idea,” says Robert Seltzer, founder of Seltzer Business Management in Los Angeles. “Dipping into the 401(k) should usually only happen for financial emergencies.” If you are tempted to make the kind of move Walz made, make sure you have enough of a cushion in your 401(k), 403(b) or IRA to get you through retirement.
]Roughly 50% of Americans have said they’ve taken an early withdrawal from a retirement plan. Those people are effectively borrowing from their future.
So why are there almost no good reasons for taking early withdrawals? Investing in education may seem like a smart move, but when you take money out of a 401(k) plan, or a 403(b) plan offered to public school employees, you miss out on the magic of compounding. Walz will miss out on the potential gains that $135,000 would have made over the next 10 years or so. If that money had been left in a 401(k) and allowed to (hopefully) rise along with the stock market, it would likely be worth a lot more than $135,000 when the time came to withdraw the funds.
That doesn’t stop people. Roughly 50% of Americans have said they’ve taken an early withdrawal from a retirement plan. Not only are those people borrowing from their future, they are also paying income tax on the withdrawal — in addition to a 10% early withdrawal penalty for those who dip into their plan before age 59½. “The IRS allows distributions for these types of withdrawals via hardship distributions, although not every plan allows those,” says Alonso Munoz, chief information officer at Hamilton Capital Partners in Atlanta, Ga.
“For most Americans, 401(k)s are the main vehicle for retirement savings and investments,” Munoz says. “Taking money out of a 401(k) prior to retirement should be a last resort. Hardship withdrawals for qualified educational expenses are not subject to the 10% early withdrawal penalty, but participants may still be subject to ordinary income taxes if their funds are pretax, or if the withdrawal portion includes any profit sharing from the employer, which is always pretax.
‘Good’ reasons for early withdrawals
Shavon Roman, a personal-finance expert with Heal Plan Invest, sees some reasons you could be justified in taking early withdrawals, including “a financial emergency; a medical issue that requires prepayment for treatment that is necessary; for shelter, transportation, food that you otherwise would not have money for,” she says. According to Roman, no-nos include making a down payment on a home, paying off consumer debt, especially credit-card debt, and — bad news for Walz — funding a child’s college education.
One reason for an early withdrawal might be the prospect of losing your home. This bitter choice is, unfortunately, something many Americans have had to grapple with in recent times. Last year, 39% of hardship withdrawals were made in order to avoid eviction or foreclosure, up from 31% in 2021. But a hardship withdrawal is an irrevocable decision: “When a participant takes a hardship distribution, they are unable to re-contribute those funds back toward their retirement savings above and beyond the annual contribution limits,” Munoz says.
Some financial analysts are more forgiving of Walz’s move. “Life happens,” says Herman Thompson Jr., a financial planner with the Innovative Financial Group in Alpharetta, Ga. “You have to have a place to live, a car to drive to work, and sometimes you have to help your family out no matter what the cost. There are also times where you make enough bad decisions that you’re staring at a pile of debt with 20%-plus interest and it feels like walls are closing in. If you find yourself in these situations, the 401(k) may be the best option.”
Investing in education may seem like a smart move, but when you take money out of a 401(k) plan, or a 403(b) plan, you miss out on the magic of compounding.
People thinking about making an early withdrawal might consider taking out a loan from their 401(k) instead. “Most 401(k)s have a loan option that will allow you to take 50% of your balance, up to $50,000,” Thompson says. “You can pay it back over a five-year period — longer for a home purchase — and the interest paid goes right back into your 401(k) account.” Failing that, tap your brokerage account, refinance your home or take out a HELOC, adds Miklos Ringbauer, founder and principal of MiklosCPA Inc., an accounting and tax strategy firm based in Southern California.
There are also specific situations where you can avoid the 10% penalty, if not the income taxes on early withdrawals. The Internal Revenue Service’s “rule of 55” takes into account that someone might lose their job before they reach the age of 59½. “If you turn 55 (or older) during the calendar year you lose or leave your job, you can begin taking distributions from your 401(k) without paying the early withdrawal penalty,” according to Charles Schwab. “However, you must still pay taxes on your withdrawals.”
Another caveat: “The 401(k) withdrawal rules for those 55 and older apply only to your employer at the time you leave your job,” Charles Schwab says. “The rule of 55 doesn’t apply if you left your job at, say, age 53. If you get laid off or quit your job at age 57, for example, you can start taking withdrawals from the 401(k) you were contributing to at the time you left employment.” And the rule of 55 becomes the rule of 50 for police officers, firefighters, EMTs and air-traffic controllers, in addition to other public-safety employees, it adds.
Retirement plans vs. pension plans
“Is it OK to dip into your 401(k)?” asks Dan Herron, principal at Elemental Wealth Advisors in San Luis Obispo, Calif. “Sure. Would I recommend it? Probably not, given that a 401(k) is going to probably be the main source of retirement savings for most people. A lot of folks say, ‘You can borrow for school, but you can’t borrow for retirement.’ When we look at paying for college, we try to not take retirement accounts into consideration — in terms of financial assets — to help pay for college. We look at other savings, like 529 plans, taxable accounts.”
Herron advises clients who are strapped for cash for college fees for themselves or family members to first look at more affordable options, such as community colleges or state schools, in addition to other methods of funding, like scholarships and student loans. “However, a lot of parents want to give their kids a leg up and avoid having debt coming out of school, which can result in them utilizing retirement funds to help their kids pay for school,” he says. “Ultimately, it is your money and you can do what you want with it.”
Retirement-savings plans are, of course, different from pension plans in that they are employer-sponsored, and each employer has an individual account, says the nonprofit Pensions Rights Center. “These include 401(k), 403(b), 457, and SIMPLE savings plans where employees typically are required to contribute in order to receive benefits, as well as profit-sharing, money purchase, Simplified Employee Plans (SEP), ESOPs, and other individual account plans. Nearly 80% of private industry workers participating in individual account plans are in 401(k)-type plans.”
In such circumstances, large investment accounts can be a gift — and sometimes a curse
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