Considering an early retirement plan withdrawal? Know the pros and cons first

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If you're contributing to a 401(k), you probably know it offers tax-advantaged investing and understand that there are many benefits to delaying withdrawals until you're eligible to retire. But to help you deal with life's uncertainties, your plan may allow you to withdraw assets before retirement.
While you may feel an early withdrawal is a harmless way — or the only way — to meet a current financial need, it's important to understand the possible effect on both your retirement account and your overall finances.

When short-term needs arise

You may be considering a 401(k) loan or hardship withdrawal if you need funds for a large immediate expense. Many, but not all, retirement plans offer you a choice between these options.
401(k) loans
If your plan allows loans, you may be able to borrow against your vested account balance at a competitive interest rate. You'll repay both principal and interest to your own account. And, if you're borrowing to make a larger down payment on a home, it could help you qualify for a lower mortgage rate and eliminate the need to buy mortgage insurance.
On the other hand, a 401(k) loan will leave you with a lower account balance until it's repaid which will reduce the potential for tax-deferred growth, potentially making it more difficult to prepare for retirement. Other downsides may include:
  • Your paycheck will be reduced by automatic loan payments. Not only will this add pressure to your budget, but if it leads you to lower 401(k) contributions, even temporarily, you could find it even more challenging to achieve your goals for retirement.
  • The risk of having the loan balance treated as a taxable distribution if you miss payments, default or fail to repay the loan before separating from your employer. In this case, you'll owe federal, and possibly state, income taxes on the distribution in addition to a 10% additional federal tax if you're under age 59½ (see "Tax Implications" below). Repaying the loan as quickly as possible could help you avoid this.
Hardship withdrawals
If you're faced with a financial emergency, you may feel your only choice is to take a hardship withdrawal. You may be allowed to withdraw funds if you have an "immediate and heavy financial need." The plan may require you to prove that you meet its definition of a hardship, such as needing funds to avoid eviction or foreclosure on your primary residence or to pay for certain medical expenses. Keep in mind that the withdrawal will permanently reduce your retirement account balance — hardship withdrawals are not repaid — and could therefore make it more difficult to get back on track. The withdrawal also may trigger taxes and a 10% additional federal tax (see "Tax Implications" below). And, you may not be able to make new contributions for a while following the withdrawal.

When change is in the air

Taking an early withdrawal from your 401(k) also can seem like a good idea when you're separating from your employer. But, a career transition is actually an important time to keep your retirement goals on track.Footnote 1 Making an informed choice about what to do with the balance in your existing 401(k) can help you protect what you've already accumulated and potentially allow your funds to continue benefiting from tax-deferred growth.
Your choices may include:
  1. Taking a partial or lump-sum distribution. This could be tempting if you need funds to cover current expenses that can't be met with other resources. But, the distribution will reduce your retirement account balance and could trigger taxes, including federal and state income taxes, and a 10% additional federal tax if you're under age 59½. Generally, 20% will be withheld for taxes from your distribution, however additional taxes may be due at tax time.
  2. Leaving money in your employer's plan.Footnote 2 If you're satisfied with the plan's investment choices and want to preserve tax deferral, this may be a good choice, at least until you're eligible to enroll in your new employer's plan. But, you won't be able to make additional contributions or take loans and may face service fees and certain restrictions.
  3. Rolling over assets to a new employer's plan. A direct (trustee to trustee) rollover,Footnote 3 if allowed by both plans, can prevent a taxable distribution and preserve tax deferral.
  4. Rolling over to a traditional IRA or converting to a Roth IRA. A direct rolloverFootnote 3 to a traditional IRA also will prevent a taxable distribution and preserve tax deferral. IRAs may offer more investment choices and beneficiary options than qualified plans, and may give you access to professional guidance, however, additional fees may apply. With a Roth IRA, you'll owe taxes at the time of conversion, but any future investment earnings may be income-tax free. Roth IRAs don't require distributions and may make it possible to pass assets across multiple generations. Distributions will be required for Roth beneficiaries.
A rollover IRA isn't right for everyone. Consider all of your choices and learn if a Rollover IRA may be right for you.Footnote 4

Tax implications

The taxes you may owe when you take a withdrawal will depend on the sort of contributions you've made to your account.
If you withdraw pre-tax contributions and any associated earnings, taxes will be due upon withdrawal. You may also be subject to a 10% additional federal tax if you take a withdrawal before age 59½.
Taxes will not be due on traditional after-tax contributions, but taxes will be due on any earnings. You may also be subject to a 10% additional federal tax if you take a withdrawal of traditional after-tax earnings before age 59½.
Next steps

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

The information we are providing is educational in nature and discusses options you may have related to your employer-sponsored plan assets. Individuals should consider their own specific facts and circumstances when considering a rollover and may wish to consult a tax advisor.

Footnote 1 If your employee retirement benefits include stock options or other equity awards, also be sure to estimate their total value upon exercise or vesting and consider how changing jobs may affect their status. For more information, contact your Human Resources department or review your plan documents.

Footnote 2 You may be eligible to do this as long as you have at least $5,000 in the account. If your balance is lower, the plan may close your account.

Footnote 3 A direct rollover occurs when rolled-over assets are made payable directly to the new custodian of a qualified retirement plan or IRA. If rollover funds are paid to you, you'll have 60 days to deposit the check into your new plan or IRA. A 20% federal income tax will be withheld. If you don't deposit the funds in the new plan or IRA within 60 days, other taxes may apply.

Footnote 4 You have choices for what to do with your employer-sponsored retirement plan accounts. Depending on your financial circumstances, needs and goals, you may choose to roll over your eligible savings to an IRA or convert to a Roth IRA, roll over an employer-sponsored plan from a prior employer to an employer-sponsored plan at your new employer, take a distribution, or leave the account where it is. Each choice may offer different investment options and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment, and provide different protection from creditors and legal judgments. These are complex choices and should be considered with care. Visit the Merrill Edge® rollover page or call a Merrill Edge® rollover specialist at 888.637.3343 for additional information about your choices.

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