The Lure of the 401(k) Is Seductive – But Watch out for Problems When You Want to Take Money Out!

It sounds like a no-brainer: Put part of your earnings into your employer-sponsored 401(k) plan now. You won’t owe taxes on that money until you pull it out in retirement, plus any earnings will also grow tax-deferred.

But as is too often the case, the devil is in the details.

Boy, Does Bank On Yourself Get Questions About 401(k) Plans!

In a recent 12-month period, we received several hundred questions from visitors to our Bank On Yourself website about 401(k) plans. Some of the questions are heartbreaking pleas for help, from people whose 401(k) money is “locked up,” and they can’t figure out how to get it out.

Here are just a few of the heartbreaking questions and comments about 401(k) problems we’ve received …

Question: I am being evicted, and I face losing my home. But I was told I could not withdraw money from my 401(k) unless I’m 59½, disabled, or have lost my job. Do I have any recourse?

Question: I just had a triple-bypass heart surgery, and I am unable to work. I have a 401(k) account but my company won’t let me withdraw money from it.

Question: I got a 401(k) sum as part of my divorce settlement. Why can’t I use the money to pay for my daughter’s college expenses?

Question: Is there a law that says my employer may prevent me from taking a loan on my 401(k)? Or is it my right?

Question: My dad is trying to take money out of his 401(k) because he was laid off from his job, but he is not being allowed to. He is 57. What can he do?

Question: I need to pay off a large balance on a credit card, as part of a divorce settlement. My company won’t let me use my 401(k) money for that.

Question: I just lost my full-time job. Why won’t they let me take money out of my 401(k) to pay down the principal on my house?

Question: I don’t get it. Why do I have to pay back a 401(k) hardship loan, when I’m the one who put the money into the 401(k) in the first place?

Question: I took a withdrawal from my 401(k) last July. Now I need to take a $12,000 withdrawal, but my plan says I’m ineligible.

These are just a few of the hundreds of questions we’ve received about problems people are having with their 401(k)s … We’ve said it before, and we can’t help but say it again:

Government-approved retirement plans like 401(k)s and IRAs have more strings than Pinocchio before he became a real boy.”

It’s true! “Putting your money in a government-approved retirement account is like putting it in prison.”

(Please note that Bank On Yourself does not provide tax, legal, or accounting advice. You should consult advisors in these areas before engaging in any transaction.)

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The Four Biggest 401(k) Plan Problems and Complaints People Have

1. The 401(k) tax issue

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If you are already aware that everything in your 401(k) account is taxable when you withdraw it, you’re fortunate. Many people think “tax-deferred” means “tax-free.” But “defer” simply means postpone.

You’ll pay income taxes on every dollar you ever deposited, and on every penny those dollars may have earned – at whatever your tax rate happens to be in the year you withdraw the money.

And that rate could well be higher than your rate today. Of course, nobody knows for sure what the tax rates will be in 10, 20, or 30 years. But most people we talk to are convinced that taxes will go up, to try to pay down the national debt. In addition, our population is getting older. More people are eligible for Social Security and Medicare, and fewer younger people are paying in to the system. Taxes, it seems, must go up.

Many of our readers asked if they could avoid paying income tax on their 401(k) withdrawals by using the money for a special purpose such as college, buying a home, or paying high medical expenses.

In a word, No. Special circumstances may help you avoid the 10% penalty for withdrawal before age 59½, but the money you withdraw from your 401(k) will be taxed. Unfortunately, your 401(k) is subject to the worst kind of taxes – ordinary income taxes, which are higher than long-term capital gains taxes [even if your 401(k) is decades old].

2. The 401(k) forced withdrawal issue

Several visitors to our Bank On Yourself website wondered, “If I’m only taxed on the money I withdraw, what if I just don’t withdraw the money? Can’t I simply let my family inherit it?”

Sadly, you cannot avoid paying taxes on your 401(k) by simply leaving the money in your account. The Internal Revenue Service wants its taxes! That’s why the government has a schedule telling you what percentage of your 401(k) account you must withdraw, every year, starting at age 70½. These withdrawals are called required minimum distributions (RMDs). You may take out more, but you may not take out less.

The government offers an easy-to-use 401(k) and IRA Required Minimum Distribution Calculator on the U.S. Securities and Exchange Commission website.

Keep in mind that every penny you withdraw will be added to your other taxable income during the year to determine how much income tax you owe the Internal Revenue Service. RMDs often push people into a higher tax bracket.

3. The 401(k) penalty issue

The Internal Revenue Service says that generally you can’t withdraw money from your 401(k) before you have turned 59½. (Some people are confused about how to calculate that date because some months are shorter than others. According to Ed Slott, who’s made a career of providing retirement income advice, the safest way to be sure you won’t run afoul of the Internal Revenue Service is to count 183 days from your 59th birthday.)

If you take money out of your account too soon, in addition to the income tax you’ll have to pay, you may also have to pay an early-withdrawal penalty.

And if you don’t take enough money out of your account soon enough – if you fail to take your Required Minimum Distributions on time – you’ll also pay a penalty.

Failure to withdraw an RMD by the deadline results in one of the most severe penalties in the tax code: 50%!

That’s right. If your RMD is $10,000 and you don’t withdraw $10,000 by the deadline, you will be hit with a $5,000 penalty – on top of the tax you already owe on the money. That means, for example, that if you’re in the 25% tax bracket, your taxes and penalty for being late on that one RMD will total $7,500! ($5,000 penalty, plus a tax of 25% on the $10,000.)

4. The 401(k) “rules and restrictions by both the IRS and your employer” issue

None of our readers asked this question explicitly, but many implied it: They expect us to be able to tell them what their 401(k) plan allows them to do. Too often, the best we can say is, “You’ll have to ask your plan administrator.”

We’re not trying to dodge the issue! The simple truth is that the Internal Revenue Service isn’t the only one making the rules for your 401(k) plan. Although the Internal Revenue Service formulates basic rules, virtually every plan comes complete with additional restrictions and requirements imposed by the plan administrator.

And the plan’s rules are allowed to be more restrictive than the government’s rules. As long as the rules are spelled out in writing and given to you when you join, are administered evenly across the board, and support the basic purpose of the 401(k) program as defined by law, a 401(k) plan may be very restrictive and yet be perfectly legal.

Rules put in place by plan administrators may impose restrictions on borrowing from your 401(k), set more restrictive loan repayment requirements, place restrictions on withdrawals, may have a very narrow definition of “hardship withdrawals,” and more.

401(k) Loans

Many of our readers had questions about borrowing from their 401(k)s. Some have hefty credit card debt they want to pay off. Others are trying to pay down student loans that are dragging on. Some just want to consolidate all their debts into one monthly payment.

So, why not borrow from your 401(k) at a lower rate, and pay off your other loans once and for all?

Taking a 401(k) loan can be tempting, but here’s what happens when you take out a loan on your 401(k):

You’re limited by what the Internal Revenue Service – and your plan administrator – allow you to borrow. You can’t borrow more than half the value of your 401(k) fund. And if your fund is valued at more than $100,000, your borrowing power is capped at $50,000.

Of course, this is limited by what your plan allows. Many, but not all, 401(k) plans permit you to borrow, but the limits may be more restrictive than what the government allows.

Generally, repayments must occur within five years.

You’ll miss out on any compound growth that your investment could have earned in the market. And if you stop or reduce your contributions while you’re paying back your loan, you’ll miss out on any company match.

You’ll be paying your 401(k) loan back with after-tax dollars.

And this really matters! If you’re in the 25% tax bracket, you’ll need to earn $125 in order to make a $100 loan payment.

And since your 401(k) money is taxed again when you withdraw it in retirement, you’re subjecting yourself to double taxation on every dollar you borrow.

Perhaps the biggest danger is that if you have an outstanding 401(k) loan and you leave your job for any reason – including being laid off or fired – you typically have to repay your loan within 60 days. (If you took out your loan after January 1, 2018, the Tax Cuts and Jobs Act of 2017 says you have until October of the following year to repay and avoid a penalty and tax hit.)

If you don’t repay your loan in time, the Internal Revenue Service says, in essence, “Hey, you didn’t borrow that money. You withdrew it!”

That means you’ll have to pay income tax on the outstanding “loan” balance, plus a 10% penalty unless you’re 55 or older. (The Internal Revenue Service says that “distributions [from a 401(k) plan, but not from an IRA] made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55” do not incur the 10% penalty. But they are still taxable.)

Can you imagine it!? You have a financial setback, and you need money. So you borrow from your 401(k). Then you lose your job. Now you really need money! But come tax time, the Internal Revenue Service demands that you pay income tax on your loan balance, plus a 10% penalty, unless you’re at least 59½—or qualify under the “Rule of 55” noted in the previous paragraph.

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401(k) Plan Hardship Withdrawals

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Many of the 401(k) questions we receive on our Bank On Yourself website relate to “hardship withdrawals.” People want to know if their “hardship” qualifies for a withdrawal, what taxes and penalties will apply, and how that will affect their overall plan. Here’s the answer about 401(k) hardship withdrawals, from Intuit, the makers of the popular TurboTax income tax filing software:

If your 401(k) plan allows hardship distributions (and not all do), you can withdraw money for yourself, your spouse, or your dependent for what the IRS deems “an immediate and heavy financial need.” Your plan may (or may not) allow withdrawals for some or all of the following reasons:

  • Certain medical expenses
  • The purchase of your primary home
  • Tuition and educational expenses
  • Payments to prevent eviction or foreclosure on your primary home
  • Burial or funeral expenses
  • Certain expenses for the repair of damage to your primary home

In every case, it’s up to your employer and the plan custodian to approve your request for a 401(k) hardship withdrawal.

401(k) Loans Must Be Repaid, but 401(k) Withdrawals Can Not Be Repaid

Note that under Internal Revenue Service regulations, a withdrawal from your 401(k) can’t be repaid. This is different from the rules regarding a loan against your 401(k). Your withdrawal will be treated as a taxable distribution and reported on an IRS Form 1099‑R.

That means the amount you withdraw will be added to your other income for the year, and you’ll pay income tax on the total. If your 401(k) withdrawal pushes you into a higher tax bracket, you’ll pay that higher rate on all your income for the year.

Also, if you’re under age 59½, you will have to pay a 10% early distribution penalty if you don’t qualify for an exception. Only in a few limited cases will the Internal Revenue Service grant an exception from the 10% penalty.

And get this: Under the rules of most plans, you won’t be permitted to make any additional contributions to your 401(k) for at least six months following your withdrawal!

So even with a 401(k) hardship withdrawal (if your plan permits it), you will probably have to pay state and Federal income tax at your current tax rate, plus a penalty of 10% of the amount you withdrew, if you’re under 59½. The money cannot be repaid. And your ability to make additional contributions to your plan may be severely restricted for at least six months.

Is There a Better Alternative Than a Government-Sponsored 401(k) Plan?

Absolutely. Thousands upon thousands of wise savers have found that the Bank On Yourself safe wealth-building strategy, based on dividend-paying high early cash value whole life insurance, has virtually all the advantages of a 401(k) plan, and none of the disadvantages.

A good place to begin your research is to compare a 401(k) plan to Bank On Yourself.

And by all means, compare a 401(k) loan to a loan against your Bank On Yourself-type policy in this championship bout.

Carefully examine the pros and cons of 401(k) plans.

You’ll also want to consider how the safety of the Bank On Yourself strategy compares to the safety of a 401(k) plan. And of course, there’s the very real possibility of a government seizure of your 401(k) account.

Then, as we’ve mentioned earlier, there’s the matter of those pesky – and potentially devastating – deferred taxes on 401(k) plans. The fact is, your 401(k) plan – and every tax-deferred retirement plan – is a ticking time bomb.

And don’t get us started on the hidden fees of your tax-deferred 401(k) plan!

Ted Benna, the “Father” of the 401(k), Wishes He Could Blow It Up! – And You’ll Be Surprised to Discover Where He Puts Most of His Own Money Today …

If 401(k) plans are so terrible, why were they created in the first place? The fact is that the Father of the 401(k) wishes he had never created the concept – and you may be surprised to learn that he now puts most of his own money in Bank On Yourself-type policies!

All of those references will help you understand the issues. But they will not tell you what Bank On Yourself can do for you, personally. Your next step, then, is to get a Bank On Yourself Personalized Solution and Recommendations, based on your specific situation.

When you request your FREE Analysis, you’ll receive a referral to an Authorized Advisor (a life insurance agent with advanced training on this concept) who will prepare your Analysis and your Personalized Solution. Why not find out how you could benefit from a custom-tailored plan today? …