All too often, retirement savers shoot themselves in the foot by treating their 401(k) like a pool of cash that they can tap any time. While retirement money is often tapped for genuine short-term emergencies, it’s abused as a way to pay bills or pay for things that should not be financed by long-term savings.
Over the years, I’ve heard of people who tap their 401(k)s for college, medical bills and even vacations. Not only is this a guaranteed way of triggering taxes — if you withdraw the money and don’t pay it back — it will hurt your chances of having enough money for retirement.
There are two ways that employees dig into their 401(k)s: 1) a loan and 2) straight pre-retirement withdrawals, where the money is taken out and never paid back. The first choice, while undesirable, won’t trigger taxes if you stay with an employer and pay back the loan before you change jobs or leave a company. Both options, though, are bad ways to access cash.
About 10% of those surveyed by Fidelity Investments took out a 401(k) loan last year. The average amount was $10,000. Of those who took out loans, the most common reasons cited were “hardship withdrawals” such as avoiding foreclosure or medical purposes.
What happens to retirement savings overall when loans or withdrawals whittle away at retirement savings? Once they got a taste of the “easy money” from their retirement kitty, about one-quarter of those polled said they reduced their overall contribution to their 401(k). Some 15% stopped saving entirely, Fidelity reported. That translates into a loss of from $180 to $690 a month in retirement income — money that can’t be made up when you leave the workforce.
How to Avoid 401(k) Loans & Withdrawals
* Set up an emergency fund and add money on a regular basis.
One of the reasons that people tap their retirement funds is that they don’t have any cash reserves. Open up a money-market account with any bank or mutual fund and set up automatic withdrawals from your checking account. That way, you’ll have money if you’re unemployed or face unexpected medical bills.
* Use the “bucket” approach for emergency savings.
At the very least, you should have at least one emergency fund with the equivalent of three months of salary on deposit. A few years ago, I had set up three funds for big monthly bills, intermediate expenses like appliance repairs and additional “failsafe” savings for college and medical expenses.
When a medical emergency did come along — and I lost a well-paying job in the same year — I was able to tap all three funds to avoid going into debt. We completely tapped out one of the funds and dug into the other two, but heavy-duty contributions before our worst year saved us from big financial woes.
* You can negotiate on debts.
Banks, medical providers and other creditors are open to the idea of negotiating down your debts. When we were dealing with some major medical bills while I was out of work, we talked directly with hospitals and doctors to cover what wasn’t picked up by insurance, which was thousands of dollars. Some bills were reduced while others were waived. Of course, you have to send in your income statements or tax returns to qualify. Then you need to figure out payment plans. Either way is better than tapping retirement money.