Should you borrow or take an early distribution from your 401(k)?

When you are short on cash, you may be tempted to borrow or take an early withdrawal from your employer-sponsored 401(k) plan account. But first, weigh the potential risks that may pose to your long-term goals.
It's not uncommon to find yourself in need of cash quickly — a major home repair crops up unexpectedly, say, or your car breaks down. During your working years, taking money out of your employer-sponsored 401(k) plan account through either a loan or withdrawal (also called a distribution) may feel like your only option for raising funds. "It's understandable that an individual who needs access to money may consider dipping into their 401(k) plan," says Kai Walker, managing director, Retirement Research and Inclusion Transformation at Bank of America.
But before you decide to pull out your retirement savings early, consider why this could prove to be a costly move — and what your alternatives are. It's a good idea to consider your personal situation and determine other potential sources of funds.
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1. You could face a high tax bill on early withdrawals

Before you retire, your employer's 401(k) plan may allow you to tap your funds by taking a withdrawal (plan rules vary, so check). If you're considering a withdrawal from your 401(k) plan account,Footnote 1 keep in mind that you may be subject to federal and state income taxes on the amount you take out, as well as an additional 10% early withdrawal federal income tax if you are under age 59½ unless an exception applies, Walker notes.

How does the early withdrawal affect your taxes?

The additional tax is based on the taxable amount of your withdrawal. Let's say your account consists entirely of pre-tax funds. In that case, taking a $50,000 early distribution results in a $5,000 early withdrawal tax (10%). Meanwhile, the $50,000 counts toward your taxable income and is subject to state and federal tax based on your tax bracket.
Here's an example of what an early withdrawal could cost you when you consider the total tax implications — and the potential investment returns you could miss out on:
The impact of taking an early withdrawal…
Amount of withdrawal:
$50,000
Ordinary income taxes:
-$12,000
Early withdrawal taxes:
-$5,000
What you get:
$33,000
…vs. leaving funds invested:
Potential value of $50,000 left in the plan for 20 years: $224,567
Notes: Assumes the account holder is under age 59½ (and no exception to the 10% additional tax applies) and has a 24% effective federal income tax rate; 7.8% annual investment returns. This example is hypothetical and does not represent the performance of a particular investment. Results will vary. Actual investing includes fees and other expenses that may result in lower returns than this hypothetical example. For illustrative purposes only. All tax calculations are estimates and should not be relied upon for detailed tax planning purposes.
As you can see, this means that in many circumstances, an early withdrawal nets you only a fraction of the spending power of every dollar you take from retirement savings.

What sorts of exceptions exist?

Tax rules provide several exceptions to the early withdrawal additional 10% tax, including taking out money to pay for qualified birth or adoption costs or withdrawals in the event of total and permanent disability. Under legislation passed in 2022, the SECURE Act 2.0, the list of exceptions was expanded to include the following:
  • Distributions up to $22,000 due to a federally declared natural disaster
  • Withdrawals of up to $10,000 for victims of domestic abuse
  • Emergency personal expense withdrawals of up to $1,000 per calendar year
  • Distributions to a terminally ill employee
  • Distributions to purchase long-term care insurance in amounts not to exceed $2,500
Your employer is not required to offer any of these distribution options in its employer-sponsored 401(k) plan. However, if you are terminally ill and otherwise eligible for a withdrawal, you may still qualify for the exception to the 10% additional tax. Frequency limitations, required certifications and other rules may apply in securing an exception to the 10% additional tax. Consult a tax professional for further guidance.
It's important to note that these taxes apply only to a true withdrawal. When you take out a loan against your 401(k) and repay it, no taxes would be imposed (unless you fail to pay back the loan as noted below).
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2. You can be on the hook for a 401(k) loan if you leave your job

Employer-sponsored 401(k) plans may — but aren't required to — allow account holders to access savings through loans. Plans vary in their loan stipulations; typically, the amount you can borrow depends on the account's value and maxes out at $50,000.Footnote 2 An advantage of a 401(k) loan over a withdrawal is you don't pay ordinary income taxes or face potential additional taxes on the borrowed amount. You must repay the loan along with interest per the loan terms, but on the bright side, repayments replenish your plan account — you're essentially repaying yourself.
Although you generally have up to five years to repay a 401(k) loan, leaving your job (or losing it) before the loan is repaid may mean you have to pay back what you owe quickly. If you can't, the loan will go into default and the unpaid balance is considered a distribution (referred to as the loan offset amount). As with an early withdrawal, you may be subject to federal and state income taxes as well as an additional 10% federal income tax if you are under age 59½ unless an exception applies.
However, you may avoid this tax treatment by repaying or rolling over the loan offset amount to a new employer's 401(k) plan (if permitted by the plan) or to an IRA as long as this is done by the federal income tax filing deadline, including extensions, for the year in which the offset occurred.
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3. You're losing an opportunity to potentially grow your savings and investments

As much as you may need the money now, by taking a withdrawal or borrowing from your retirement account, you're interrupting the potential for the funds to grow through tax-deferred compounding — and that could make it more difficult for you to reach your retirement goals, Walker notes. Taking funds out of your plan account might mean missing out not only on the potential growth of the money you have invested but also on any growth of that money's earnings.
"As a general rule, dipping into your retirement funds to cover a short-term need could end up costing you more in the long run," says Walker. "If it's possible, I'd encourage you to consider other ways to access cash that could be more beneficial to your long- and short-term financial goals."
"Before you consider taking a loan or a withdrawal from your 401(k), which may be your only retirement savings, make sure you've explored other options that could meet your needs," Walker says. If you have a financial advisor, you may want to discuss the pros and cons of other borrowing options, such as a personal loan, home equity loan or line of credit.
Also, remember the value of having a sufficient emergency fund so that you can avoid borrowing money for short-term needs altogether. Set aside these funds in a separate account so you have the money available — if and when you need it. (For more on protecting your finances from unexpected events, see "Preparing for the big 'what-ifs' in your financial life.")
"Your retirement savings should be your last resort," Walker says. By tapping into this long-term savings during your working years, you could be impacting your future financial security.

Next steps

Footnote 1 Any earnings on Roth 401(k) contributions can generally be withdrawn federally tax-free if you meet the two requirements for a "qualified distribution": 1) At least five years must have elapsed from the first day of the year of your initial contribution or conversion if earlier, and 2) you must have reached age 59½ or become disabled or deceased. If you take a non-qualified withdrawal of your Roth 401(k) contributions, any Roth 401(k) investment returns are subject to regular income taxes plus a possible 10% additional tax if withdrawn before age 59½ unless an exception applies. State income tax laws vary; consult a tax professional to determine how your state treats Roth 401(k) distributions.

Depending on the basis of company matching contributions (traditional or Roth if offered), taxes on these contributions and any earnings on them may be due upon withdrawal. You may also be subject to a 10% additional tax if you take a withdrawal prior to age 59½ unless an exception applies.

Footnote 2 401(k) plans that permit disaster relief loans can, at their discretion, increase the maximum allowable loan amount to qualified individuals to $100,000.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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