401k Withdrawals: When Should You and When Shouldn't You?

If you're using a 401k as a component of your retirement plan, you may be wondering whether you can dip into it if you need to. Maybe you're finding that the economy is tougher than you anticipated; maybe you've met a financial hurdle you couldn't possibly have foreseen; or maybe your retirement planning has gone better than you expected and you want to celebrate by spending some of your hard-earned savings on a vacation or a nice purchase.

If any of these are the case, you should first look for the money elsewhere. Typically, 401k withdrawals are a sticky wicket in the financial-planning world, and there are a variety of potential penalties and other hurdles to overcome if you want to pull cash from one. So if you have something it's easier to withdraw from -- say, a money market account or even a simple savings account -- you should go there first.

But if a your 401k is your only (or best) option, there are a few things you should know about 401k withdrawal.

Hardship 401k Withdrawals. Because your 401k is meant to serve only as a source of retirement income, it's difficult to pull cash from it before it matures. Hardship withdrawals are also costly.

The first thing to keep in mind about hardship 401k withdrawals is that they're only available to you in a limited number of situations:

•        Medical expenses for you or your dependents.
•        Purchase of a principal residence, or repairs to that residence.
•        Payment of college tuition and related expenses.
•        Payments necessary to prevent eviction from your home.
•        Funeral expenses.

And even these aren't easy. The IRS imposes a 10 percent early withdrawal penalty if you're younger than 59-and-a-half. There are a few cases in which you can pull a penalty-free withdrawal, but the restrictions are harsh.

Loans. You can take out a loan from your 401k, but unless you've got money to burn, it'd be much smarter to find the money elsewhere. While 401k withdrawal loans are relatively easy to take out -- there's no credit check since you're borrowing from yourself and the remaining funds function as collateral -- you only have five years to pay back the loan, and if you can't pay it back in time, you'll incur penalties and taxes. Not to mention the loss to your retirement fund.

If you're thinking about a 401k withdrawal, the best advice most financial planners will offer is: Stop thinking about it. At least until you hit your 60th birthday. Unless it's an emergency, there are other places to find the money you need.