A 401(k) is a qualified retirement savings plan established by an employer to which eligible employees make contributions on a post-tax and/or pretax basis – typically through payroll deductions – up to a specified annual limit ($18,000 for 2016; plus $6,000 “catch-up” if you’re age 50 or over). If you’re fortunate, your employer will make non-elective or matching contributions to the plan on your behalf – free money that can greatly boost the value of your account over time. Today, 42% of companies match dollar-for-dollar, up from just 25% in 2011. Prior to 2013, a 50-cent per dollar match was the most common formula.
Earnings in a 401(k) grow on a tax-deferred basis. You have to wait until you turn 59½ before you can start withdrawing money from your 401(k) without a penalty. The account is designed to be an investment vehicle where money grows long-term, not a fund where people store cash they can easily access in an emergency. In fact, tax law actively disincentivizes savers from using their 401(k)s that way. Here's what happens if you try.
If you withdraw money before you turn 59½, you’ll owe a 10% early withdrawal penalty in most cases – in addition to federal and state income taxes. If you’re in the 28% tax bracket, for example, a $10,000 early withdrawal will cost you $3,800 in federal taxes and penalties, plus your state’s income tax rate, if applicable: You’ll end up seeing only $5,400 of that $10,000 withdrawal, for example, if you live in a state with 8% income tax. (For exceptions to the 10% penalty, see When a 401(k) Hardship Withdrawal Makes Sense.) You may also have to forfeit a portion of your account balance if you withdraw too soon and before you are fully vested. (Read How Do You Calculate Penalties on a 401(k) Early Withdrawal? to learn more.)
Because early withdrawals are so expensive, it’s a good idea to try to avoid tapping into your 401(k) before age 59½. If you need cash now and you don’t have any other options, you may be able to borrow from your 401(k): With this type of loan, you can withdraw up to $50,000, or 50% of the vested balance in your 40l(k) account. You typically repay your account over a period up to five years (or more if you use the loan to purchase a home), paying back a little more than you borrowed to make up for some of the interest or capital gains the money would have accrued if it had remained in the account.
Sounds easy enough, but there is a catch: Your employer may not offer these loans, especially if you work for a smaller company. (For more, read 401(k) Loan Vs. IRA Withdrawal.) Also be aware: If you are terminated or choose to leave your job, you may have to pay back the loan in as little as 60 days – or trigger the 10% early withdrawal penalty.
If you’re eligible for one, a Roth IRA can be a good option if you want to fund a retirement account and still be able to access some of it for emergencies, such as unemployment or a serious illness. When you invest using a Roth IRA, you can take out your contributions at any time with no tax penalty as long as you don’t touch any earnings; if you withdraw any investment gains, you will incur early-withdrawal penalties. (See How to Use Your Roth IRA as an Emergency Fund for additional details.)
If you decide to dip into your Roth IRA, keep in mind you don’t get to “return” the money later: Any money you pay back to your Roth is considered part of that year’s allowable contribution ($5,500 for 2016, or $6,500 if you are 50 or older). Plus, any time you make a withdrawal, you lose the benefit of letting that money grow tax-free over many years. That's why it’s a good idea to limit withdrawals to times when you have no other option.
The short answer to whether keeping cash in your 401(k) is useless is yes; cash is unlikely to earn much income or do you much good in an emergency. Taking money out of your 401(k) early will trigger a 10% penalty tax under most circumstances.
If you need to dip into a retirement account to cover crucial expenses, consider taking a 401(k) loan if your employer offers one, or tapping your Roth IRA, which allows penalty-free withdrawals any time – as long as you don’t touch the earnings on the Roth.
There is a time, however, when the rules about withdrawing money from your 401(k) change radically. By April 1 of the year following the year that you turn 70½, you have to start withdrawing money each year – an amount called a required minimum distribution (RMD) – whether you want to or not. If you don’t, you risk paying a hefty penalty tax equal to 50% of the amount you should have withdrawn. Don't Forget to Take Minimum Distributions will fill you in on what you need to know.