Five reasons not to dip into your 401(k) this hiloday season
by David BarksdaleMr. Barksdale is a financial consultant with BenefitGuard. Visit here.
December 20, 2016 — The spirit of giving that surrounds the holiday season is something that brings joy and happiness to individuals around the globe. Unfortunately, this season also brings with it the temptation to spend beyond what your means allow.
In fact, a 2013 survey from Harris Interactive indicated that 57% of parents would be more than willing to incur debt if it meant that their children would have a happy holiday. If that is a temptation that you face this holiday season, allow us to offer several reasons why your 401(k) should not be an option for holiday financing.
Whether you withdraw funds as a loan, hardship withdrawal, or early distribution, taxation is going to be an issue. When withdrawing from a standard 401(k) as an early distribution or hardship withdrawal, you will owe income tax on the amount withdrawn. This will range anywhere from 10% to 39.6%. The effect that this has on your retirement savings can be profound. As an example, assume that you take an early withdrawal of $2,000 from your 401(k) for holiday expenses. After taxes (and not factoring in penalties), the amount that you will actually take home is between $1,208 – $1,800; however, the amount that you will have lost in retirement (assuming 30 years until retirement and 8% interest) is $20,125.31.
While having to pay 10%-39.6% on your withdrawal is an incredible drawback to raiding your 401(k), your obligation to the IRS is not likely to end there. With few exceptions, the IRS will penalize you an extra 10% for withdrawing early from your account. This means that rather than receiving the $1,208 – $1,800 mentioned earlier, you are likely to only take home $1,008 – $1,600 from your $2,000 withdrawal.
Reduced Retirement Savings
Sudden and unpredictable financial events are eventualities in life. Because of this, most personal finance experts stress the need to save for an emergency fund that can help mitigate the negative effects of these unforeseen events.
This is fantastic advice; however, it is easy to focus so much on the unpredictable risks that we face each day, and forget about the very predictable risk that we each will face later in life; that is, voluntarily or forcibly entering into retirement, and the shortfall in income that it can create.
This has rarely been more pertinent than it is today, as we see retirement safety nets, such as social security benefits and company pensions, begin to disappear. In this environment, it has become essential for each individual to take control of their retirement by saving early and consistently.
With the above in mind, consider again the earlier example. To get the $1000 or so that you may want for gifts, you would need to withdraw $2,000 from your 401(k). It’s tempting to think that the relatively small amount being withdrawn is but a small personal sacrifice for such a positive desire.
However, it is anything but a small sacrifice. The 35 year old wanting to retire by age 65 stands to lose over $20,000 from that single withdrawal; 10 times the original amount. A 25 year old with the same retirement goal would lose more than double that ($43,450).
Double Tax on Loan Repayments
Many individuals incorrectly believe that taking a loan from their 401(k) is a safe and savvy means of financing emergencies or other expenses. This belief is largely due to the fact that 401(k) plans generally have lower interest rates on loans and that you repay the balance to your own account.
What isn’t factored into this belief is the double taxation that will occur on the loan amount. The IRS requires individuals to repay 401(k) loans with after-tax money, and does not offer a tax deduction on repayments. Despite this fact, the money will still be taxed when it is withdrawn from the 401(k) in retirement. This effectively means that the loan amount is double-taxed by the time you receive the money later in life.
Consider our running example of taking out $2,000 from your 401(k) for holiday expenses. If this is done as a loan from your 401(k), you will not pay taxes or penalties on the amount up front. However, when you repay the $2,000 loan, you will need to do so from after-tax money.
The gross earnings that you would need to do this, assuming a 25% tax bracket, is $2,666.67. Later in life, when you withdraw that $2,000, you will end up owing taxes on the amount at your ordinary income tax rate. Assuming that you are still in the 25% tax bracket, this means that you will owe $500 in federal taxes, making the total amount paid in federal taxes $1,166.67 for a loan withdrawal of $2,000. Considering this example, one would be hard-pressed to think of 401(k) loans as a safe or savvy means of financing emergencies and other expenses.
Your 401(k) is a designated savings account with the goal of providing you a means of income during retirement. To encourage savings, the IRS has established rules and penalties for individuals wanting to draw from their retirement funds early. If you feel your need to finance holiday expenses is so great that you are willing to face these penalties and obstacles, you are almost certainly breaking the most fundamental rule of personal finance, which is to live below your means. If this bad habit becomes routine, it will ultimately lead to heavy debt burdens and a life of limited financial options.
The holiday season makes us re-evaluate our priorities, and can help us feel a spirit of generosity and caring for those around us. If you find yourself caught up in this spirit of giving, but want to give more than you are comfortably able, consider these 5 points before looking towards your retirement as a means of financing. You will thank yourself later.