Dear Carrie: If you’re younger than 59, and a half, is it possible to withdraw money from your 401(k) without having to pay it back? — A Reader

Dear Reader: The balance in your 401(k) can be a tempting source of cash when times are tough and you have no other options. Yes, it’s possible to withdraw early without having to pay it back, depending on your personal situation and your specific plan.

But being possible doesn’t necessarily mean it’s practical for your financial future — and the IRS doesn’t make it easy. There are a lot of rules and regulations. So before taking any money from your 401(k), I’d take a step back and carefully review the basics as well as the short- and long-term costs.

Basic Taxes and Penalties

First, no matter your age, all 401(k) distributions are taxed as income according to your tax bracket the year that you withdraw the money, unless you have a Roth IRA. What’s more, unless you meet specific criteria, early distributions are subject to an additional 10 percent penalty. Together, this could take a huge bite out of your distribution — not to mention your future potential retirement savings.

Criteria You Have to Meet

If your plan allows it, you may qualify for a hardship distribution as long as you prove immediate heavy financial need. The amount of a hardship distribution is limited to your own contributions to the 401(k), and possibly your employer’s contributions, but doesn’t include your income earnings or savings. The terms of proof once again depend on your plan, but in general, the IRS defines immediate and heavy financial need as:

–Medical expenses for you, your spouse or dependents.

–Costs directly related to the purchase of your principal residence — excluding mortgage payments.

–Postsecondary tuition and related educational fees, including room and board for you, your spouse or dependents.

–Payments necessary to prevent you from being foreclosed on or evicted from your principal residence.

–Funeral expenses.

–Expenses to the repair of damage to your principal residence.

What You Stand to Lose

Regardless of why you need the money, you’ll have to pay both income taxes (unless it’s a Roth IRA) and an additional 10 percent penalty. Let’s put that into real numbers. Say you want to take $20,000 from your 401(k) and you’re in the 25 percent tax bracket. Income taxes on your distribution could be $5,000. Now add the 10 percent penalty of $2,000. You could end up having to deduct about $7,000, or 35 percent, from your $20,000 distribution — a hefty price cut.

Next, figure out how much you’d lose in potential earnings over time. For example, if you had a total of $20,000 in the account, and let that money grow at a hypothetical annual interest rate of 5 percent for another 15 years, you’d have over $41,500 — more than double your money!

Finally, even if you continue to make contributions after an early distribution, annual 401(k) limits will make it hard to recoup your losses. On top of that, in certain circumstances, you’re not allowed to make additional contributions for six months after the withdrawal. That’s six months of lost savings.

This example is hypothetical in nature and not intended to represent, predict or project the performance of any specific investment. Charges, expenses and taxes that would be associated with an actual investment are not reflected.

Penalty-Free Options

There are some exceptions to these rules. For instance, if you leave or lose your job at age 55 or later, you can take a lump sum 401(k) distribution. You can also set up a payment schedule of substantially equal payments over your lifetime, which has to be a minimum of 5 years or until you reach age 59 and a half — whichever is longer. This is known as separation of service, and while both situations are penalty-free, you’d still pay income taxes.

The penalty is also waived if you become disabled: You’d pay for medical expenses exceeding 7.5 percent of your adjusted gross income. If you die, a payment is made to your beneficiary or estate. Otherwise, it would be waved if you were mandated to give your distributions to a former spouse under a qualified domestic relations order.

Another Less Costly Option — a 401k Loan

A 401(k) loan is potentially a less costly way to take some cash if your retirement plan allows it. There are no penalties or taxes, but you do have to pay interest. On the plus side, that interest will go back into your account, so in a sense you’re paying it to yourself. However, repayment schedules are strict and failure to repay may trigger penalties and taxes. Also, if you lose your job or change jobs, you’ll almost certainly have to pay back the entire loan within 60 days. If you don’t, once again you’ll likely be hit with penalties and taxes.

The Ultimate Cost

To me, taking an early distribution should be a last resort. I’d advise you to think carefully and talk to your tax advisor. Make sure you understand what a distribution would mean in terms of upfront dollars and lost opportunity for growth. While it may seem like the answer to a current financial need, you could be sacrificing your future financial security by depleting your retirement savings now. That’s the ultimate cost.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book. You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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