Personal finance

More people are dipping into their retirement accounts. Why experts say it's a terrible idea

Financial experts say withdrawing from your 401k should be a last resort

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Inflation continues to put a strain on our budgets. And now, more people are dipping into their retirement accounts to help bridge the gap.

To put it in perspective, an expert we talked with says if you haven’t gotten a raise to keep with the pace of inflation, then you’ve essentially lost a month’s worth of pay over the last year. 

Recent reports from Fidelity Investments, Bank of America and Vanguard found 401k loans and withdrawals are on the rise. Vanguard says nearly 3 percent of its 401k accounts took a hardship withdrawal in 2022 -- a record high.

What’s the difference between a 401k loan, early withdrawal and hardship withdrawal?

With a 401k loan, you are basically borrowing from yourself. There usually isn’t a penalty for this type of loan and the money won’t be taxed. But not every plan offers them.

If you opt for an early withdrawal, you will have to pay taxes on the money and will likely get hit with an additional 10% penalty.

In extreme cases, you may be able to avoid the 10% penalty if you can prove hardship. Examples include medical expenses, buying a home, or preventing eviction or foreclosure.

Financial experts say withdrawals should be a last resort because you could not only lose that money but also because of the power of compound interest.

“First of all, you have to cut every single expense that is unnecessary,” said Ivan Gonzalez, a financial advisor. “Second, try to avoid credit cards because it’s a very dangerous trap. Third, if you go for your retirement plan, just understand that you’re going to lose about 30% of whatever you withdraw due to taxes and penalties."

So where can you find extra cash?

Gonzalez said if your boss won't give you a raise, ask for more hours at work. If you have a hobby, look for ways to turn that into a part-time job.

If you own your home, it may make more financial sense to tap into a home equity line of credit. And if you have an employee stock purchase plan, liquidate that before withdrawing from your 401k.

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