Dumb Money Move No. 4: Use your 401(k) or 403(b) plan as a source of emergency funds

Posted Aug 7th 2008 6:00AM by Daniel Solin
Filed under: Personal Finance

This post is part of a series where personal finance expert Dan Solin looks at money moves that may seem smart in tough economic times, but are actually quite dumb. See all 12.

Rising gas and food prices, the disappearance of home equity, downsizing by large and small employers and a credit crunch are a perfect storm for cash-strapped investors. Many are tempted to tap into low-hanging fruit: their 401(k) and 403(b) plans.

Is this a good idea?

Other than as a last resort, this answer is "no."

Even in good times, the number of employees who cash out of their retirement plans is alarming. More than 45% of departing employees cash out of their 401(k) plans.

The consequences of doing so are draconian.

First, your employer will withhold 20% of the value of your 401(k) plan for taxes and the amount you receive will be taxed at your ordinary income tax rate (both federal and state).

Second, if you are less than 59 1/2 years of age, you will get slammed with an additional 10% penalty.

This double whammy can sharply reduce your net proceeds. Someone in the 25% bracket with $100,000 in her 401(k) can end up with only $53,000, assuming the distribution bumps her federal tax rate to 28% and that she has to pay a 9% state tax as well.

Avoid cashing out of your 401(k) or 403(b) plan if you possibly can. It can be a very expensive way to get cash.

Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).

Tags: 401k, 403b, retirement, retirementsavings

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Reader Comments (Page 1 of 1)

8-29-2008 @ 8:33AM

Christina said...

What I never see mentioned is the fact that one will have to pay federal and state taxes on their 401(k) whether they withdraw the money now or after retirement. We assume the rate will be reduced because one will be in a different tax bracket. But, what rate will that bracket be in five, ten or twenty years? Plus some individuals have an employer's match. Some are willing to lose that 10% penalty because of this match even though taxes will be taken on that portion as well.

8-06-2008 @ 1:45PM

darren said...

they always talk about 401k cashouts but there are other way to use your 401k money be for retierment get a 401k loan its a good way to pay off credit card and the interest that you pay. goes back into your 401k account.

8-07-2008 @ 7:50AM

Taddy said...

This is really great blog.

8-07-2008 @ 8:07AM

Warren said...

"goes back into your 401k account."

The problem is that while the money isn't in there, it isn't growing. Leave your 401K alone and use the payments you would have used to "pay yourself back" to pay down the debt instead.

8-07-2008 @ 9:37AM

Obama Voter said...

DUMB MONEY MOVE #5:

TRUST A REPUBLICAN WITH YOUR MONEY.

JOHN MCCAIN = MORE OF THE SAME.

8-07-2008 @ 2:43PM

pbihomes said...

i just read that there are some idiot companies that want to give their employees debit cards that will withdraw from their ira's

buy a starbucks from your ira and pay $12.00 for it duh

brought to you from the same idiots that let people buy homes with 125% financing so they could get cash

duh

8-23-2008 @ 10:33AM

Ed at AAFR said...

Excellent, excellent advice for future retirees. I incorporated it into the AAFR (American Association of Future Retirees) blog with a backlink to you at http://www.aafr.org/2008/08/23/simple-advice-on-tapping-into-your-retirement-fund-early-dont/ . Keep up the good work!