The holiday season is a wonderful time to spend with family and friends. The spirit of giving that surrounds the holidays can serve to strengthen these relationships and bring people closer. Unfortunately, this same spirit of generosity can bring with it the temptation to spend more than you’re comfortably able. If you find yourself wanting to spend more than you should this holiday season, consider the 10 reasons below before using your 401(k) to finance your expenses.

 

Income Taxation: 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from a standard 401(k) as an early distribution or hardship withdrawal, you will owe income tax on the amount withdrawn.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 even more costly when compounded over time.

 

Penalties: 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.

 

Double Tax on Loan Repayments: 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 Despite this fact, the money will still be taxed when it is withdrawn from the 401(k) in retirement.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.

 

Loan Repayments after a Job Loss: If you decide to take a loan from your 401(k), and then change jobs or get terminated before paying it back, you will be required to pay the full amount of the loan immediately or within a few months. If this is not done, the full amount of the outstanding loan will be counted as taxable income and can be penalized with an additional 10% fee.

 

60-day Rollover Complications: So long as the money is returned to a qualified retirement plan within 60 days of the 401(k) withdrawal, the IRS may waive the tax and penalty requirements. If you are planning to use this option as a makeshift loan, seriously reconsider. Regardless of your intent to return the money to a qualified plan, your 401(k) provider will be required to withhold 20% from the withdrawal for federal taxes. Additionally, if the IRS feels that you’ve abused this provision to take a short-term loan rather than simply to transfer between institutions, they can disallow the rollover and make the full distribution subject to taxes and penalties.

 

Required Loans before Hardship Withdrawals: The IRS has allowed for early withdrawals from a 401(k) if the participant is facing an immediate and heavy financial need. However, most plans will require that the participant first take out a loan before a hardship withdrawal can be approved. This means that you will face double taxation on loan repayments, and will put yourself at risk for more taxable income if the loan is not paid back.

 

Suspended Contributions: If you take a hardship distribution from your 401(k) plan, you will likely be prohibited from making elective contributions and employee contributions to the plan for at least 6 months. By taking the hardship withdrawal, not only will you reduce your 401(k) balance, but you won’t be able to make up for the loss in the near future.

 

Reduced Market Growth on Your Savings: Every dollar that you remove from your retirement account is a dollar that does not compound overtime. To achieve your retirement goals, you will likely need to replace that dollar and the interest that it would have earned throughout your career.  Unless you are able to do that by cutting into other categories in your budget, you are reducing your retirement savings and thus the income you will live off in retirement.

 

Difficult to Replace Retirement Savings: If you are an older investor, and choose to subject your assets to taxation, penalties, and lost growth by withdrawing early from your 401(k), you are much less likely to have sufficient time to replace the retirement savings.

 

Bad Habits: 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 negative consequences of prematurely withdrawing funds from your retirement to finance holiday expenses can be extreme and far-reaching. If you find yourself getting overextended this year, keep these 10 points in mind before raiding your 401(k). You’ll thank yourself later.


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David joined BenefitGuard after having spent the past 9 years working for the largest worldwide provider of 401(k)s. His passions include: economics, personal finance, investing, woodworking, and family.

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