Why the possibility of job loss is the perfect reason to contribute to your 401(k)

Many employees don’t contribute to their 401(k) because they have an immediate need for their entire paycheck, or they fear being without money in the event of a job loss. But, hardships, especially the loss of a job, would actually make those 401(k) funds more easily accessible.

Normally, employees can’t withdraw from their 401(k) before the they turn 59.5 years of age without facing penalties. However, hardship withdrawals, loans, and 401(k) rollovers can provide penalty-free access to those funds. 

401(k) Hardship Withdrawals

If you’re not 59.5 years of age and need to access funds that you contributed to your 401(k), you may be able to make a withdrawal for certain hardships. Those hardships, per IRS guidelines, “must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.”

These hardships include:

• Specific medical expenses.
• Expenses associated with purchasing a primary residence.
• Tuition and related educational costs.
• Payments needed to avoid eviction from or foreclosure on a primary residence.
• Funeral or burial costs.
• Repair costs for casualty damage to the employee’s primary residence (excluding recent limitations).
• Losses (including income) from a Federal disaster.

401(k) Loans

Some 401(k) plans permit loans, which are distinct from hardship withdrawals. These loans can be used for various purposes, including general needs or specifically for purchasing a primary residence.

A 401(k) loan can be more appealing than a standard personal loan, as it doesn’t require a credit check, and it isn’t reported to credit bureaus. Although you do pay interest on 401(k) loans, this interest isn’t a traditional expense like that of a conventional lender; instead, you’re effectively “paying the bank of you.” When you pay interest on your 401(k) loan, that money goes back into your own retirement account.

Furthermore, as long as the loan is repaid according to the plan’s terms, the withdrawal isn’t taxable at that time. The amount borrowed remains tax-deferred until it’s withdrawn through a normal distribution. Additionally, the repayment terms for 401(k) loans can be more favorable than those for traditional loans, often allowing for longer repayment periods.

401(k) Rollovers

When you leave your employer, your 401(k) funds become more accessible as you can roll them into a Roth IRA, which has less restrictions on withdrawals.

Although you will now owe taxes on the amount that you roll over (versus paying taxes upon retirement), you’re free to withdraw your contributions penalty-free.

Imagine that you only contributed to your 401(k) in 2024 and the total amount was $23,000. On January 1, 2025, you leave your employer and decide to roll over the 401(k) to a Roth IRA. This will be a taxable event for 2025, which means that the taxes due on the $23,000 rollover will be due by the April 2026 tax deadline. Remember that these are earnings from 2024. So, while you do have to pay taxes on the earnings, you benefited by deferring your taxes for over one year. If you’re in the 22% tax bracket, that results in $2,760 in money that you didn’t have to part with before April of 2026.

More Benefits to Contributing to a 401(k)

The benefits of contributing to a 401(k) extend beyond just providing support during hardships.

If your employer contributed to your 401(k) through a matching plan, you’re entitled to keep those funds when you leave the employer, as long as you met certain requirements set forth by the 401(k) plan. These requirements generally include being employed with the company for a certain amount of time. So, by simply contributing to your 401(k), you’re getting free money from your employer.

In addition, contributing to a traditional 401(k) can serve as a valuable tax-planning strategy since these contributions are made with pre-tax dollars. This means that they’re not counted in your AGI (adjusted gross income). AGI is commonly used in various applications, such as determining student loan repayment amounts and eligibility for certain tax credits. Since 401(k) contributions reduce your AGI, allocating a portion of your paycheck to your 401(k) can help you qualify for tax credits or lower student loan payments, which could potentially result in hundreds or even thousands of dollars in savings each year.

Start Contributing to Your 401(k)

Contact your employer’s human resources department to get details on your company’s 401(k) plan. Some employers auto-enroll employees to encourage saving. So, it’s to your advantage to review your company’s plan and your individual account to make any needed adjustments, including the contribution type (pre-tax or after-tax), the contribution amount, and an important setting that’s commonly forgotten, your investment source/s.

Resources:

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions#2