How to avoid penalties if you dip into your 401(k) prematurely

By MARK SCHWANHAUSSER

Knight-Ridder Newspapers

There's one problem with watching your 401(k) balance grow: It can tempt you to dip in and spend it. Do everything you can to resist that urge.

"The 401(k) is a retirement vehicle," said Jeffrey Ross of Arnerich Massena & Associates Inc., a Seattle-based 401(k) consulting firm. "You're probably going to need every penny you save in your 401(k) -- and more -- to survive in retirement. If you use that money for things in your life prior to retirement, you are shortchanging yourself on the back end of your life. It's as simple as that."

But sometimes there's no way around it. So, weigh your options carefully to minimize penalties, taxes and the drain on your account.

If you siphon money from your account prematurely (typically that's before age 59-1/2), Uncle Sam will levy a 10 percent fee, and California will gobble up 2.5 percent. Plus, you'll owe federal and state income taxes on the entire amount you withdraw. A rough rule of thumb is that you'll lose about 50 cents on the dollar.

You can skirt the early-withdrawal penalties if you become disabled, take early retirement after age 55 or qualify as a hardship case. The definition of a hardship varies from 401(k) to 401(k), but it typically includes staving off eviction or incurring heavy medical expenses. Some plans allow you to withdraw funds without penalty to pay for a down payment on a first home or a year's college tuition, but check with your company first.

Another option is to borrow money from your 401(k). Most -- but not all -- employers allow loans. Typically, you can borrow your entire balance if it's less than $10,000, or half of larger balances. Interest rates, the length of the loan and repayment terms will vary.

Many people -- experts and savers alike -- consider 401(k)s to be an acceptable alternative to other loans because a) you pay a reasonable rate of interest (unlike credit cards), and b) you pay that interest to yourself. It's like guaranteeing yourself that rate of return on your loan amount.

Still, that overlooks a cost that could change your thinking -- and your future: the cost of lost opportunity. If you left that money invested in stocks, it could grow much, much faster. Earning 9 percent when the Dow Jones Industrial Average is up more than 25 percent so far this year is painful and costly. (Of course, a fixed-rate loan would look prescient if the stock market plunged. But who's wise enough to predict when that will happen?) Moreover, many people reduce or suspend their 401(k) contributions while they repay a loan. That can have long-term implications.

"If you are missing out on this market, it's a shame," said Tracey Curvey, vice president of Fidelity Institutional Retirement Services Co. in Marlboro, Mass. "If you're not putting the full amount aside and it's not invested, right now it's almost a crime."

There are three other significant factors or restrictions on loans to consider:

n Because you pay off your loan with after-tax dollars, your payments are taxed twice: first when you make the payments, which are not tax-deductible, with money you've already paid taxes on; then when you withdraw the money in retirement.

n If you borrow from your 401(k) to buy a house, once again, you cannot deduct the interest you are paying, as you could with a mortgage loan. That's because the 401(k) itself is the collateral, not the house.

-- Worse, 401(k) loans generally are due when you leave your company. If you can't dip into savings to square the bill, your ex-employer will report the unpaid balance to the Internal Revenue Service and state Franchise Tax Board as an early withdrawal. The following April 15, you'll owe income taxes and penalties -- but where will you dredge up those? Possibly by tapping your remaining 401(k) balance -- and incurring another round of penalties and tax.