Raid your 401(k) for living expenses?

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Dear Dr. Don,
My job of 16 years has left the state, and I chose not to follow. I will be getting unemployment benefits soon, and I remember reading about people needing to withdraw from their 401(k) account while being unemployed to make ends meet. Can you explain the “good/bad” of doing this, if in fact I end up needing to do that?
— Stacey Stationary

Dear Stacey,
Once you are separated from service, you can no longer borrow against your 401(k) plan. If your account balance is more than $5,000, you have the option of keeping the money in the plan, but you would want to know the plan’s provisions for hardship withdrawals for former employees separated from service. For that information, you need to talk to the plan administrator.

The plan may allow hardship withdrawals, but the Internal Revenue Service has vigorous standards for what is a hardship withdrawal. Even if you meet those standards, you will still owe the income tax on the distribution and, if you are younger than 59½, you may owe a 10 percent penalty tax.

Alternately, you can roll over your 401(k) plan into a traditional or Roth individual retirement account, or IRA. There is no loan program available with an IRA account, but you do have a 60-day window to move funds from the 401(k) into the IRA account if you have the 401(k) plan administrator cut you a check. The advantage of a traditional IRA is that only the distributions are immediately taxable; the untouched balances remain tax-deferred. Convert to a Roth IRA, and the entire conversion is immediately taxable.

I’d argue against getting a check because if you do, the money is subject to mandatory withholding. It’s much better to do a trustee-to-trustee transfer in which the money is sent directly from the 401(k) plan to the IRA custodian. Then if you decide to take an early distribution, you will only owe taxes on the distribution, plus the possibility of a 10 percent penalty tax.

To my mind, it’s not whether it’s good or bad to tap these funds. It’s whether you need this money to survive while you’re unemployed. If you have a choice to keep this money invested for your retirement, don’t tap the funds. You’re still going to want to retire someday, and you’ll still want a retirement nest egg.

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