Q: How bad is it to tap my 401(k) account before I retire? Are there any times when there’s no penalty for withdrawals?
A: The biggest problem about tapping into your 401(k) is that any money you take out will be money you’re no longer earning interest on. Early on in your life, that might not be such a problem, but the closer you get to retirement, the more that money and that interest matters.
Typically you can borrow money as long as you pay it back within five years. And if you don’t pay back that 401(k) loan in five years then you'll owe a 10% federal penalty tax, as well as regular income tax on the outstanding loan balance, according to AXA Equitable Life Insurance Company.
Check your plan, because you may be allowed hardship withdrawals. But there are penalties. According to AXA, “hardship withdrawals are generally subject to federal (and possibly state) income tax.” And afterwards, you may not be able to contribute to your 401(k) plan for six months. That means you not only lost compounding interest on the money you took out until you pay it back, but you’re also half a year behind on saving for retirement now.
So it is possible to borrow money from your 401(k) account, but you don’t want to use that money for a new car or vacation. That money should only be withdrawn for emergencies, or if you want to use it for a down payment on a primary residence.