Financial Perspectives: Think twice about taking from your 401k

 

The past two years have been trying times for many people in the Northeast. Due to layoffs or reductions in hours worked per week, some folks have been forced to take money out of their retirement plans to make ends meet. There can be significant consequences to taking premature distributions or loans from retirement plans.  We are going to review a few examples to help shed some light on this topic.

First, if you take a distribution from your 401k, or other qualified retirement plan such as a 403b or 457, as well as traditional IRAs, before you are 59-and-a-half years old, you will be subjected to a 10 percent penalty in addition to normal income taxes.  Let’s consider the following hypothetical example:

DISTRIBUTIONS

Mary from Mayfair would like to redo the kitchen in her home.  She is 45 years old and has $80,000 in her 401k.  The kitchen will cost $25,000 dollars.  She decides against a home equity loan and opts for a distribution from her 401k.

Because Mary needs $25,000, she will need to take out more to cover the taxes and the penalty.  To be exact, Mary will need $35,714.

Total Distribution:         $35,714

Federal Income Tax:      $7,143 (assumes Mary is in the 20 percent tax bracket)

10 percent Penalty          $3,571

Net Distribution              $25,000

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As you can see, that kitchen wound up costing $10,714 more than expected.  Besides costing more, Mary reduced her future retirement fund by the amount of the distribution.  If Mary had left that money in the account, it could have potentially grown to $114,540 if she was able to earn 6 percent per year for 20 years.

LOANS

Now let’s consider if Mary had taken a loan from the 401k plan instead.  Fortunately she would not owe any income taxes since there is no distribution.  The downside to this option occurs with the repayments.

Most 401k plans require a loan to be repaid over a five-year period or less. For purposes of this example let’s assume 60 monthly payments.  The kicker is that the loan repayments need to be made with after-tax dollars.  This may not seem like a big deal, but in essence, Mary will pay tax twice on the money being used for the loan.  First, when she receives the money in her paycheck and then again when she withdraws the money at retirement.  Sound a little confusing?  It can be.  Normally when you invest in a retirement plan you do it with pre-tax dollars – meaning that your taxable income is actually reduced by the amount that you are investing.  Let’s review the following example to try and make this clear:

Total Loan                                                   $25,000

6 percent Interest                                       $4,000

Total Repayments                                      $29,000

Taxes Paid on Income for repayment    $5,800

Taxes Paid at time of withdrawal            $5,800

Total Cost                                                     $40,600

Note: tax calculations assumes 20 percent federal tax rate at the time income is originally earned and at the time of withdrawal.

Retirement plans generally require you to pay interest on loans.  The interest is actually paid to yourself (but also with after-tax dollars).  As you can see from the example, the loan results in $4,000 in interest.  As previously mentioned, taxes are paid first when the income is earned and then again when the money is withdrawn (presumably at retirement).  In this case, the total tax impact for the 401k loan is $11,600.  Remember that even though the money is repaid with after-tax dollars it is put back into a pre-tax account.  If the loan were not repaid, it would be categorized as a distribution and Mary would be subject to ordinary taxes and a 10 percent penalty, if under age 59-and-a-half.

On a flat-dollar basis, the loan would actually cost more than the distribution, but keep in mind the second tax payment would not be made until the money was withdrawn from the account.   The amount of taxes paid at retirement could even be higher than what we are showing here if the loan repayment amount grows significantly.

Hopefully we have convinced you that it makes sense to find some other way to pay for that kitchen renovation other than taking money out of your retirement plan either through a distribution or a loan.  If financing is necessary, using a home equity loan could certainly make more sense.

Registered Representative, Securities offered through Cambridge Investment Research, Inc., A Broker/Dealer, Member FINRA/SIPC and Investment Advisor Representative, Cambridge Investment Research Advisors, Inc. a Registered Investment Advisor.  Family Wealth Services, LLC and Cambridge are not affiliated.

Jim Heisler is a Certified Financial Planner with Family Wealth Services in Holmesburg. You can read all his Financial Perspective columns here.

Registered Representative, Securities offered through Cambridge Investment Research, Inc., A Broker/Dealer, Member FINRA/SIPC and Investment Advisor Representative, Cambridge Investment Research Advisors, Inc. a Registered Investment Advisor.  Family Wealth Services, LLC and Cambridge are not affiliated.

Jim Heisler, CFP®, CDFA™, CASL™

Family Wealth Services, LLC

8725 Frankford Avenue

Philadelphia, PA 19136

jim@familywealthservices.net

215-332-4968

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