Why 401(k) early withdrawals are on the rise — and what to consider before you do it

Intended as a tax-advantaged way to save for retirement, 401(k) plans are increasingly becoming somewhere Americans are turning in a financial pinch. Last year, "a record share of 401(k) account holders took early withdrawals from their accounts" to help cover "financial emergencies," The Wall Street Journal said in a report, citing internal data from Vanguard Group.

In part, this shift has to do with the fact that "values in these accounts have risen substantially," making people "more comfortable dipping into their accounts when needed," said the Journal. But it's also related to the "conflicting financial forces'' Americans are facing, as the price on everything from groceries to car insurance "keeps climbing."

But while the money in your nest egg may seem like a reasonable enough place to turn when you're caught between a rock and a hard place financially, it actually has some notable financial consequences — both near-term and long-term. 

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What are the ramifications of 401(k) early withdrawals?

When you make an early withdrawal from a 401(k) — defined as any money pulled out of your account before you're 59 ½ years old — you'll generally face a 10% tax penalty on the amount (though there are some exceptions). Additionally, said Time, you'll owe "the applicable income taxes on the amount withdrawn."

Withdrawing from your 401(k) account also effectively subtracts money from your retirement funds. Plus, said Money, "you aren't just losing the amount you withdraw, you're also losing the money you would have earned on the withdrawn funds."

That's because if you invest the funds in your 401(k) and your funds earn interest through those investments, "the principal amount in your 401(k) continues to increase over time," said Money. In turn, "higher principals earn more interest, which you can then reinvest for even more gains."

Are there ever any exceptions to the early withdrawal penalty?

As mentioned, the IRS does allow some penalty-free early 401(k) withdrawals, in which case you would not pay the 10% tax penalty. These exceptions can include instances such as:

• Total and permanent disability
• Terminal illness
• Unreimbursed medical expenses up to 7.5% of your adjusted gross income
• Losing or leaving a job when you are age 55 or older
• Being called to active duty
• Repaying debt to the IRS
• Preventing foreclosure on a primary home
• Covering burial expenses after a death

Ultimately, however, "each plan has slightly different rules regarding hardship withdrawals and what qualifies as an emergency situation, so you'll need to speak to your employer to find out if your circumstances qualify," said Money.

What are some alternatives to a 401(k) early withdrawal?

While making an early withdrawal from your 401(k) plan is possible, it's not exactly ideal. Indeed, said Investopedia, "borrowing from your 401(k) or withdrawing money from your IRA before you have retired is generally a bad idea because it can set you back years in reaching your retirement savings goals."

If you're facing a financial emergency and are in need of some funds, you might consider these alternatives before tapping the money you've started setting away for your retirement:

• 401(k) loan: "For many, 401(k) loans are a better option," said Intuit TurboTax, because "as long as you pay the money back during the required time period, you won't have to pay taxes on the amount withdrawn." Additionally, "the interest you'll pay is added to your own retirement account balance."
• Personal loan: A personal loan also can help you cover costs in the interim. It will provide you with a lump sum of money upfront that you'll repay in fixed installments over time, with interest.
• Home equity loan: If you own a home, another option is to tap into your home equity, which is "the difference between the mortgage loan amount and the value of your home," said Investopedia. Home equity loans tend to have lower interest rates than personal loans because your home serves as collateral (which also means you could lose it if you fail to repay the loan).