The financial and credit crisis of 2008 has caused a record rise in unemployment and has put millions of households under the poverty line worldwide. In the U.S., millions of people have lost their jobs and savings and many of them have considered liquidating their 401k plans as an option to avoid living on a tight budget.
How the 401k Works
Your 401k plan is a defined-contribution plan financed by pre-tax payroll deductions. As an employee you are allowed to put aside tax-deferred income and your employer funds your 401k account with matching dollar-for-dollar contributions. In general, 401k contributions are withdrawn from your pre-tax salary and until you reach the age of 59 1/2 you cannot collect the tax-free funds. However, your employer’s contributions to your 401k are conditional on a vesting requirement. Vesting forces you to work for your employer at least 1,000 hours per year to be 100 percent vested after seven years or less and gain access to your 401k employer contributions. However, vesting is subject to exceptions by Federal Law.
Why You Should Not Liquidate Your 401k
Although liquidating your 401k can offer your financial relief during tight financial times, there are important consequences that you need to take into account in order not to hurt your financial future.
In particular:
1. Financial health during retirement years is jeopardized
401k is a retirement plan that you start while working with an aim to be solvent during your retirement years. By liquidating your 401k before the age of 59 1/2 all the money you have been contributing to your 401k until that time won’t be available to cover for your needs beyond retirement age. Should you get sick or should you get in a financial emergency, your retirement account will be empty when you will not be able to work anymore. If you have no money left to which you can fall back on for paying high medical bills may even lead you to the court. Retirement years become tougher with no money set aside for financial emergencies and no ability to work.
If you take a 401k hardship withdrawal to cover for a financial need for yourself, your spouse or your dependents, the government considers this amount as income. Should you file for unemployment benefits, you will have to wait until this amount is spent to be eligible for unemployment benefits again. Although state laws for unemployment benefits vary greatly, most states consider 401k hardship withdrawal as a pension income. If you file for unemployment benefits while having received a 401k hardship withdrawal, your unemployment benefits will be reduced by 50% of the amount that you withdrew from your 401k.
3. Taxes and penalties
If you liquidate your 401k before the age of 59 1/2 you will owe taxes on the withdrawn amount plus a 10% early-withdrawal penalty, which is paid in addition to regular income taxes. Unless you are able to demonstrate true financial hardship, you cannot avoid the additional tax penalty. On the other hand, if you wait until your 401k matures, the 401k funds are taxable. In any case, if you cash out your 401k earlier than maturity, the government will find a way to get your money through various policies that they have initiated.
4. Starting over again
There is nothing more discouraging than starting over with your retirement account. Younger people have the strength to work hard, even at two jobs, to make a living and put money aside on their 401k plan. As you get older, you don’t have the strength and the patience to start building your 401k from the beginning for the most part because it will take you years to replace the money you liquidated before maturity. If you are already near retirement age, you are very unlikely to make up for this money until you retire.
Conclusively, there is little doubt that liquidating your 401k is a bad idea. Even if it solves your financial emergency today, it will definitely hurt your financial future during retirement years. By liquidating your 401k, you will put yourself in a vicious circle of debt and financial instability trying to make up for the money you withdrew early from your 401k. If you are seriously considering liquidating your 401k, consult a financial adviser to help you deal with your financial emergencies while you can still work to pay off your debt.
