401(k) Penalty Flags

You’re in a pinch, and you’re tempted to borrow or withdraw from your 401(k). Strict governmental rules are in place to discourage use of 401(k) funds for purposes other than retirement. Here are some ways to avoid being called for a penalty.

You don’t have that money working for your future and your retirement | In addition to reducing your retirement nest egg, you may miss upticks in your investment portfolio. For example, if you had reduced your 401(k) value by borrowing or withdrawing in February 2009, you would have missed out on the 60 percent gain the S&P 500 had between March and December.

You will end up being taxed twice | When you repay the loan, you pay in after-tax dollars. Then when you retire and begin withdrawing from your 401(k) for your living needs, you’ll pay tax on those withdrawals. Note, too, that everyone is required by the government to begin withdrawing at age 70½, and the minimum amount depends on the value of the 401(k).

If you leave your company, you’ll have to pay back all you’ve borrowed | In most plans, you’ll have to pay the full loan within a few months. If you can’t repay it that quickly, it gets considered a withdrawal that will be taxed that year as opposed to a tax-free loan. If you’re under 59½, you’ll have to pay an additional penalty of 10 percent.

The bottom line is being sure you have exhausted all other options before you turn to your 401(k). If this is the only option, see if your need qualifies for a hardship withdrawal in your company’s plan. You can repay the loan without penalty or taxes.

Companies have guidelines for what qualifies, such as a medical expense, purchase of a primary residence or repairs to this residence after major casualty losses. You also have to demonstrate that you have no other means to cover this hardship.