Education Center » Catching Up » Considering an early retirement plan withdrawal? Know the pros and cons first

Considering an early retirement plan withdrawal? Know the pros and cons first

considering-an-early-retirement-plan-withdrawal_220x146

If you’re contributing to a 401(k), you probably know it offers tax-advantaged investing and understand that there are many benefits to delaying withdrawals until you’re eligible to retire. But to help you deal with life’s uncertainties, your plan may allow you to withdraw assets before retirement.

While you may feel an early withdrawal is a harmless way — or the only way — to meet a current financial need, it’s important to understand the possible effect on both your retirement account and your overall finances.

When short-term needs arise

You may be considering a 401(k) loan or hardship withdrawal if you need funds for a large immediate expense. Many, but not all, retirement plans offer you both of these options.

401(k) loans

If your plan allows loans, you may be able to borrow against your vested account balance at a competitive interest rate. You’ll repay both principal and interest to your own account. And, if you’re borrowing to make a larger down payment on a home, it could help you qualify for a lower mortgage rate and eliminate the need to buy mortgage insurance.

On the other hand, a 401(k) loan will leave you with a lower account balance until it’s repaid which will reduce the potential for tax-deferred growth, potentially making it more difficult to prepare for retirement. Other downsides may include:

  • Your paycheck will be reduced by automatic loan payments. Not only will this add pressure to your budget, but if it leads you to lower your 401(k) contributions, even temporarily, you could find it even more challenging to achieve your goals for retirement.
  • The risk of having the loan balance treated as a taxable distribution if you miss payments, default or fail to repay the loan before separating from your employer. In this case, you’ll owe federal, and possibly state, income taxes on the distribution in addition to a 10% additional federal tax if you're under age 59½ (see “Tax Implications” below). Repaying the loan as quickly as possible could help you avoid this.

“We know that life is full of unexpected expenses and circumstances, and understand there are times when you may need to consider an early withdrawal from your 401(k). We’re here to help. Our team of knowledgeable Retirement Education Specialists can help you understand your options and the associated consequences1 before you make a decision.”

Sylvie Feist
Director
Financial Guidance Services
Bank of America Merrill Lynch

Hardship withdrawals

If you’re faced with a financial emergency, you may feel your only choice is to take a hardship withdrawal. You may be allowed to withdraw funds if you have an “immediate and heavy financial need”. The plan may require you to prove that you meet its definition of a hardship, such as needing funds to avoid eviction or foreclosure on your primary residence or to pay for certain medical expenses. Keep in mind that the withdrawal will permanently reduce your retirement account balance — hardship withdrawals are not repaid — and could therefore make it more difficult to get back on track. The withdrawal also may trigger taxes and a 10% additional federal tax (see “Tax Implications” below). And, you will not be able to make new contributions for a while following the withdrawal.

When change is in the air

Taking an early withdrawal from your 401(k) also can seem like a good idea when you’re separating from your employer. But, a career transition is actually an important time to keep your retirement goals on track.2 Making an informed choice about what to do with the balance in your existing 401(k) can help you protect what you’ve already accumulated and potentially allow your funds to continue benefiting from tax-deferred growth.

Your choices may include:

1. Taking a partial or lump-sum distribution. This could be tempting if you need funds to cover current expenses that can’t be met with other resources. But, the distribution will reduce your retirement account balance and could trigger taxes, including federal and state income taxes, and a 10% additional federal tax if you're under age 59½, or under 55 and separated from service. Generally, 20% will be withheld for taxes from your distribution, however additional taxes may be due at tax time.

2. Leaving money in your employer’s plan.3 If you’re satisfied with the plan’s investment choices and want to preserve tax deferral, this may be a good choice, at least until you’re eligible to enroll in your new employer’s plan. But, you won’t be able to make additional contributions or take loans and may face service fees and certain restrictions.

3. Rolling over assets to a new employer’s plan. A direct (trustee to trustee) rollover,4 if allowed by both plans, can prevent a taxable distribution and preserve tax deferral.

4. Rolling over to a traditional IRA or converting to a Roth IRA. A direct rollover4 to a traditional IRA also will prevent a taxable distribution and preserve tax deferral. IRAs may offer more investment choices and beneficiary options than qualified plans, and may give you access to professional guidance, however, additional fees may apply. With a Roth IRA, you’ll owe taxes at the time of conversion, but any future "qualified distributions" of investment earnings will be free from federal tax and may be state tax free5, as well. Roth IRAs don’t require distributions and may make it possible to pass assets across multiple generations. Distributions will be required for Roth beneficiaries.

You have choices for what to do with your 401(k) or other type of plan-sponsored accounts. Depending on your financial circumstances, needs and goals, you may choose to rollover to an IRA or convert to a Roth IRA, rollover a 401(k) from a prior employer to a 401(k) at your new employer, take a distribution, or leave the account where it is. Each choice may offer different investment options and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment, and provide different protection from creditors and legal judgments. These are complex choices and should be considered with care.

Tax implications

The taxes you may owe when you take a withdrawal will depend on the sort of contributions you’ve made to your account.

If you withdraw pre-tax contributions and any associated earnings, taxes will be due upon withdrawal. You may also be subject to a 10% additional federal tax if you take a withdrawal before age 59½.

Taxes will not be due on traditional after-tax contributions, but taxes will be due on any earnings. You may also be subject to a 10% additional federal tax if you take a withdrawal of traditional after-tax earnings before age 59½.

Learn more and take action

  • For questions or help with evaluating your plan distribution options, contact a
    Merrill Lynch Retirement Education Specialist at 1.877.637.1786.
  • Review this grid for more information on the possible advantages and drawbacks of your various retirement plan distributions.
  • If you’re in a career transition, Managing Your Career Transition may help you make informed decisions about the next steps for your retirement assets.
  • If you’re considering a 401(k) loan, here are some additional things you may want to consider.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

The information we are providing is educational in nature and discusses options you may have related to your employer-sponsored plan assets. Individuals should consider their own specific facts and circumstances when considering a rollover and may wish to consult a tax advisor.

 
Print

1 Merrill Lynch and its representatives do not provide tax, accounting or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Please consult your own independent advisor as to any tax, accounting or legal statements made herein.

2 If your employee retirement benefits include stock options or other equity awards, also be sure to estimate their total value upon exercise or vesting and consider how changing jobs may affect their status. For more information, contact your Human Resources department or review your plan documents.

3 Generally, you may be eligible to do this as long as you have at least $5,000 in your account. If your balance is lower, the plan may distribute your account.

4 A direct rollover occurs when rolled-over assets are made payable directly to the new custodian of a qualified retirement plan or IRA. If rollover funds are paid to you, you’ll have 60 days to deposit the check into your new plan or IRA. A 20% federal income tax will be withheld. If you don’t deposit the funds in the new plan or IRA within 60 days, other taxes may apply.

5 Any earnings on Roth 401(k) contributions can generally be withdrawn tax-free if you meet the two requirements for a "qualified distribution": 1) At least five years must have elapsed from the year of your initial contribution, and 2) you must have reached age 59½ or become disabled or deceased. If you take a non-qualified withdrawal of your Roth 401(k) contributions, any Roth 401(k) investment returns are subject to regular income taxes, plus a possible 10% additional federal tax if withdrawn before age 59½.

ARR3DRR8

AC260ED1 (JCF*******801)