Thinking of withdrawing your 401K? Don’t.
Withdrawing from your 401k should be a last resort.
Do not withdraw money from your 401K account unless you are going to be homeless on the street or need a life saving medical procedure and have exhausted every avenue of reasonable financial resources.
For everything else, we recommend that you slow down and look at whether you really need to move to a new or bigger home, buy a new boat or car, start a new bakery, or pay off those grad school loans today.
If your answer is still a Yes, we recommend you a) get a roommate, b) find a 2nd job, c) ask family or friends to invest in your bakery, or d) be happy with where you currently live.
Drawbacks to Using Your 401(k) to Buy a House
If you need to cash out your 401k to purchase a home, you probably shouldn’t be buying a home. Why? Your 401k is for retirement and meeting your basic needs in 20+ years. It is not for shelter today. It can be a challenge to unlock home equity during retirement for living expenses.
Even if it's doable, tapping your retirement account for a house is problematic, no matter how you proceed. You reduce your retirement savings, not only in terms of the immediate drop in the balance but in its future growth.
Take this scenario as an example. You have $100,000 in your 401(k) account, and are considering taking out $50,000 to purchase a home. The remaining $50,000 could grow to $272,000 in 25 years with a 7% annualized return. If you leave the $100,000 in your 401k instead of using it for a home purchase, that $100,000 might grow to $544,000 in 25 years while earning the same 7% compounding return. This could be the difference between $900 a month in retirement income and $1,800 a month.
Our advice is to stay in your current living situation, save up cash for a down payment and then purchase the home when you can afford a down payment with cash. And, remember when you move to a new home, you are going to encounter unexpected expenses such as moving costs, furniture, and home repairs. Have you done a realistic home budget yet? Knowing how much you will need in addition to your down payment will provide peace of mind and remove buyer’s remorse when you do eventually sign the papers on a new home.
Drawbacks to Using Your 401(k) to Pay Off Student Loans
Student loans are not free money. You should think of them as money you borrow to make an investment in your financial and career future. In other words, if you take a loan for school, you should expect your income to increase to a level that makes it comfortable for you to meet your lifestyle goals and pay back your loan.
Taking money out of your 401k to pay student loans reduces your ability to retire in the future. Most folks need to save 10 times to 15 times their income by the time they are 67 to retire comfortably. The higher income you have, generally the higher your multiple of income needs to be. This is because your taxes on retirement withdrawals will likely be higher if you need more income to live.
Ask yourself how you will catch up to hit your retirement savings checkpoint if you withdraw $50,000 or $100,000 from your 401k to pay down your student loan?
Typical student loan balances are $57,000. Let’s say you need to withdraw $75,000 from your IRA to pay off a student loan. Why $75,000? Because you will likely owe tax on the withdrawal of around 24%. The long term impact of that $75,000 withdrawal will probably cost you $407,000 of retirement savings 25 years from now. That is the equivalent of $1,350 in monthly retirement income.
While IRAs offer an exception to the early withdrawal penalty for college expenses, early 401k withdrawals are always subject to a 10% penalty (see new CARES Act exception below).
If you have done a good job of forecasting the return on your education, you should have sufficient income to meet your student loan debt as well as your living expenses.
What if your student loan payments are challenging to afford?
If you are in a circumstance where your student loan payments are a challenge to afford, you may want to consider one of the following options:
An income based-repayment plan (IBR). These programs set payments based on your earning rather than your loan balance.
Ask your employer for help. Some employers offer funds to help tackle student loan debt. Begin this conversation with your HR department. Be transparent and explain your situation. This includes how much you owe, how much you’re paying off per month, and so forth. The more honest you are, the more likely HR is to empathize with you and provide an honest answer in return.
Refinance your loans to consolidate or lower your monthly payment. You can refinance both federal loans and private loans. It doesn’t cost anything to refinance student loans, and you may be able to reduce your monthly payment or pay off your debt faster.
Make a plan to pay your loans within your current income. Work with your financial advisor to forecast how much you can pay to extinguish your student loan debt while balancing the need to keep saving for retirement.
Try to find a better paying job. If you aren’t earning enough income to build your emergency fund, pay your loans, and save for retirement, then consider looking for a better paying job or incorporate a side hustle into your routine.
How do I recover if I have used my 401k to purchase a home or pay off my student loans?
If you have used your 401k to pay off your student loans, then at the very least, whatever your monthly student loan payment amount, that should now be going into your accounts dedicated for retirement. That repayment should be in addition to contributing at least 15% of your annual income to your retirement.
Take this scenario as an example. If you make $140,000 a year and your student loan payments were $800 a month before you paid them off, you should be contributing at least $30,600 a year to retirement accounts. This is $2,550 per month. Does that sound like too much to contribute? Well, if you start with zero retirement savings and set aside that amount for each month for 25 years earning 7% interest, you should wind up with $2 million in retirement. That should get you about $80,000 a year in retirement income. Add that to social security and you will likely be OK if you don’t live too high on the hog and have your mortgage paid off at retirement.
If you are married or have a partner and you both work, become extreme savers will also aid you in recovering your retirement contributions. Live off of one partner’s salary and save 100% of the other’s salary toward retirement. The benefit of doing this is you will learn to live on less money and you will build your retirement savings pretty rapidly. Seeing those balances increase can bring you great psychological comfort and peace of mind.
If you bought a large home with plenty of space, consider getting a roommate or renting your extra space on AirBnB. I had socially distanced drinks with friends this weekend who rents out their finished basement with no contact check-ins even during the Covid measures.
Unsure which accounts to save in for retirement? Contact your financial advisor.
What if you’ve been impacted by the COVID-19 pandemic?
The CARES Act of 2020 provides relief for individuals affected by the COVID-19 pandemic. This includes allowing retirement investors access to up to $100,000 of their retirement savings without being subject to early withdrawal penalties (normally 10%) and with an expanded window of three years to pay the income tax on the amounts withdrawn.
Ordinarily, if you take a hardship withdrawal from your 401k, you permanently reduce your balance. However, with the CARES Act, if you pay back what you had withdrawn within 3 years, you will be refunded the income taxes you paid.
Even with these new rules in place, it is still advisable to exhaust every other resource before tapping into your retirement accounts. Every dollar you take from your 401k today means less you’ll have in retirement tomorrow.
If you are in a circumstance where you are heavily considering a withdrawal from your 401k and have exhausted every other resource available to you, then the CARES Act will provide you with decent relief. Speak with a financial advisor to help you:
Navigate between taking a 401k loan and a 401k distribution,
Build a retirement repayment plan into your budget, and
Assess your retirement savings level relative to your income and age.
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About the Author
Peter Newman is the president of Peak Wealth Planning. He offers financial planning, investment management, retirement income, insurance and estate planning advice. Peak Wealth is a fee only financial advisor based in Champaign, Illinois.