Should 401(k) Plans be Used for Emergencies?

The number of Americans accessing their 401(k)s for emergencies has risen, based on a new study conducted by Vanguard. Vanguard is one of the largest 401(k) providers out there, and they released some new numbers last year that highlights some concerns that we have in the financial community. Now, their overall percentage of people going to their foreign key loans early is still relatively low, but the trend is continuing to grow over time. And this really just highlights the concern that a lot of us don’t have adequate emergency funds or cash reserves to meet some of these unexpected life events that tend to come up. Now, why is this a big deal? Well, if we’re looking at a 401(k) plan, which is what we typically talk about and most people have for their retirement savings, there’s some pretty specific rules. We have to be careful of if we’re going to go access those. The big one, of course, is we’re pulling money out of the market. So there’s an opportunity cost of access to those funds. But more importantly, these funds can come with some tax consequences. Additionally, there’s some different rules around hardship withdrawals for medical expenses. First time home purchases, or other things that you might have to prove. And if you can’t prove the funds are used for those types of events, there could be an additional 10% tacked on on top of your state and federal taxes. So that can become a pretty expensive way to access funds. Now, that might be your last resort, but we want to talk about today as well. Maybe there’s some different ways around this. And if you’re someone that you’re thinking of accessing your 401(k) early for some of these unexpected events or expenses come up, I would encourage you go meet with the tax advisor like we have here at Centennial Wealth Advisory, to make sure you can meet some of those exceptions and avoid that additional 10%. But what are some other ways we could go access it? Well, one option would be look at taking like a 401(k) loan. Well why is that better? Well you’re still pulling money out. So there’s still that opportunity cost of losing investment growth. But because you’re taking that debt on debt is usually tax free. Now if you’re someone that’s continually adding contributions into that plan, that additional payment now that comes with that loan might just be absorbed in your cash flow of what’s already going into that retirement plan. Now, if you’re someone where you had to turn off contributions or you don’t have anything going into that plan, you need to be careful because this could hurt your cash flow. This is what’s going to come back to just your specific situation, your goals, your financial independence, and all these other things that we want to be thinking about to make sure that we don’t impact cash flow. That can ultimately hurt us down the road. But, I mean, with an individual a couple of years ago and they had some big expenses come up and we started to look at, well, how can we get access to money? And we did go down this 401(k) loan because they’re going to be retiring in a couple of years. So the idea was as well, if we take out this loan, then once they retire, they’re going to default on the loan because they’ve separated from service. But it sounds worse than it is. Basically, the taxes that are paid when you default or they retire. But the point is, is they’re in a much lower income bracket at that point. So you could actually get the money out now and pay taxes on it later when they’re in a lower rate. The other option is just have the right savings plan in place. You know, we often think again, that we just got to put money into our 401(k) plans. And that’s a great start. But in my opinion, once you max out your match from your employer, let’s start to think about other places. We could own assets. And I was meeting with some individuals recently that came to one of our dinner events. They’re on the younger side. And we were talking about this very concept of how do we build more flexibility into our retirement plan. You know, the traditional just save a new 401(k). I think that’s starting to change because this idea of early retirement or having more control of our money or has more flexibility is starting to become more front of mind to a lot of people. And the point is, is we we want to have that flexibility later. We need to be doing that now. We need to be building those savings in those other places. We always hear about diversification from, you know, stock bond mix. But what I think is more important is diversification from tax standpoint. Should we have everything in a 401(k)? Maybe we should be saving to a Roth IRA outside of that plan, or an after tax brokerage account away from our 401(k) pointers. These places are going to give us more flexibility.