I know it can be very tempting to tap into your 401(k) especially if you are feeling a little tight in the budget.  As best as you can you should resist this temptation because doing this comes with penalties. However every withdrawal doesn’t come with penalties, here are some possible exceptions:

- Medical expenses by you, your spouse or any other dependent

- To cover the purchase of a primary residence(can’t be your summer home)

- All tuition related costs, which includes books and room and board

- To cover the cost of being evicted or to prevent foreclosure on your home

- Funeral expenses(including your own)

- Some home repair expenses(be careful here)

Under normal circumstances you can start taking withdrawals penalty free when you reach age 59 ½, however there are some additional circumstances when you can even take withdrawals penalty free as early as age 55.  Please refer to the document here for more information on that.

So you now decide that you must withdraw money and it doesn’t fit into one of the above categories then it is considered a hardship withdrawal.  Let’s look at what that will actually cost you.

The first cost is that you lose the long term compounding effect of your money and that can be significant.  Let’s say you are 35 years old and you plan to retire at 60.  You currently have $50,000 in your 401(k) and you have an issue requiring a $20,000 withdrawal.  Your current salary is $75,000 per year.  You contribute 10% to your 401(k) annually and your company matches 4%.  Finally we are assuming a 8% rate of return and 3% annual raises.  If you didn’t take the withdrawal and left your money alone you would have approximately 1.38 million available at retirement.  On the other hand if you did take the withdrawal you will have approximately 1.24 million.  That $20,000 withdrawal will actually cost you close to $140,000 in retirement money.  Unfortunately for many people they can’t fathom numbers like this and the price of doing this gets lost in our got to have it now society.   However any way you look at it that is a lot of money.  By the way this is the website I used to calculate those numbers.

Secondly there are penalties that must be paid as well.  The first penalty is an early withdrawal penalty which is equal to 10% of the amount of the withdrawal.  So in our example that penalty would equal $2000.  It doesn’t stop there because Uncle Sam needs his piece of the pie so you will pay federal income tax on the amount you withdrew.  In our example you would probably be in at least a 30% tax bracket which means additional taxes of $6000 on your withdrawal.  Finally Mr. State has to put his hand in the pot as well and you have to pay state taxes.  Let’s assume 6% which means another $1200.

So when you add up the grand total that $20,000 hardship withdrawal will actually wind up costing you about $150,000 in lost income taxes and penalties.  I know you are still thinking is it worth it.  I guess the real answer to that question is what do you need the money for?  Once you answer that question then you have to think is this really worth $150,000.

Here is another good article on the topic -