William Lako: When emergency strikes, should your clients tap into a 401(k)?

When an emergency occurs and you need cash, that lump of money sitting in your retirement account suddenly looks very tempting.

I recently spoke with an investor who experienced an emergency and wanted to take a loan from his 401(k) until he received his insurance settlement. He was very aware that his 401(k) should be his last resort and was struggling with the decision. Of course, he also received unsolicited advice to take a hardship withdrawal. Thankfully this investor was not only thinking through the situation, but he also sought professional advice.

To start, distributions from your 401(k) will have a 10% penalty tax if you are younger than 59 ½. Distributions are also taxed as ordinary income, which would result in an additional withholding of 10% to 37% for tax purposes. Keep in mind that this is just federal tax—you may also owe state tax on a withdrawal. Secondly, even if you fall into one of the exceptions that waives the 10% early withdrawal penalty, you'll need proof for the IRS. For example, if you are withdrawing $7,000 for medical expenses, you'll need to have receipts for $7,000 in medical expenses; otherwise, the IRS may deem it as a premature distribution, and you will owe the penalty and perhaps more for underpayment of taxes.

Loans are different in that you can pay back the loan with interest to your 401(k). However, not all plans offer loans. The provision for loans is in the plan documents your employer designed, so only some plans allow loans. A few plans even have a review process to determine if the loan should be allowed when the business owner, plan trustee, and even the plan administrator want to protect an employee's financial future. This can be a safety net for both employees who need to leave their retirement savings untouched and the employer's responsibility as a fiduciary.

Loans are also often limited by the types of money you can borrow from. Some plans may specify that you can only borrow against your contributions and not your employer's matching contributions. You may be subject to vesting rules on your employer's contributions, and of course, loans are generally limited to the lesser of half your 401(k) balance or $50,000. All loans must be repaid with interest, although both the principal and interest payments are made to your own retirement account, not to a bank. Any money borrowed from a 401(k) account is tax-exempt, as long as you pay back the loan on time; therefore, a 401(k) loan is not claimed on your tax return.

If you believe you will remain employed longer than the term of your loan and you will not default on your loan payments, a 401(k) could be a source of short-term funds in very unique and extenuating circumstances. However, this exemplifies the importance of having an emergency fund to weather disasters that may happen. 401(k)s are retirement investment vehicles, not a glorified savings account.