Fees may take their toll over time, but here’s a mistake that does damage immediately: cashing out a former employer’s 401(k) plan in order to pay off student loans, credit card debts or other expenses. Although it’s liberating to jettison high-interest debt, the price of this freedom is high. You’ll owe federal and state taxes on the entire amount, plus a 10% early-withdrawal penalty if you’re under age 55. If you face a combined federal and state tax rate of 30%, withdrawing $50,000 would cost you $20,000 in taxes and penalties if you’re younger than 55.
A better strategy, even for small 401(k) balances, is to roll the money into an IRA or a new employer’s 401(k), or leave the money with your former employer if you’re happy with the investment choices. On a bright note, a recent analysis by the Employee Benefit Research Institute found that more workers appear to be saving early retirement-plan distributions rather than spending the money.
Borrowing from your 401(k) isn’t as destructive as cashing it out, but it could compromise your ability to amass the amount you need to retire on schedule. Participants in 401(k) and other employer-provided retirement plans can typically borrow half of their balance, up to $50,000. Interest rates are generally low, and you repay yourself. The rub: If you lose your job before you’ve paid off the loan, you’ll usually have just 60 to 90 days to pay off the balance. Otherwise, the loan balance will be taxed, and if you’re younger than 55, you’ll owe a 10% early-withdrawal penalty, too.
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Even if you repay the loan, borrowing from your 401(k) could put a dent in your retirement savings. The money you borrow won’t be invested in stocks or other investments that could grow at a faster rate than the interest you’re paying on the loan. The damage will be magnified if you suspend or reduce contributions while you’re repaying the loan.
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