“The long-term consequences of that are going to be very painful,” she tells CNBC Make It.
If you’re considering cashing out your 401(k) to cover your expenses after a layoff, there are a few major reasons why financial experts say it should be your last resort. Here’s what to know.
One of the main reasons financial experts advise against withdrawing money from your 401(k) after you’ve been laid off is the potential tax consequences. You’ll generally need to pay income tax on any money you withdraw, which could result in a higher tax bill.
Say you withdraw $100,000 from your 401(k) after being laid off. At tax time, that money will be combined with your previous annual income and may result in you being bumped into a higher tax bracket, Lester says.
On top of potentially owing local, state and federal taxes, you may also owe an additional 10% tax penalty for withdrawing your retirement funds before reaching age 59½, per the IRS. In certain circumstances, it’s possible to make a penalty-free hardship withdrawal, but specific conditions must be met.
And since taxes and penalties can be pretty costly, you may end up with less money than you initially expected, Lester says.
“You may look at the number in your 401(k) and think ‘Oh my gosh, I have $100,000,’ but you don’t actually have $100,000,” she says. “Depending on your tax bracket, you may only get half of that.”
In addition to potentially facing a costly tax bill, cashing out your 401(k) may negatively impact your ability to meet your long-term retirement goals.
When you withdraw funds invested through your 401(k), that money loses out on the opportunity to continue growing through the power of compound interest. While you can invest more money later on, you can’t get that time back.
“The greatest money-making asset anyone can possess is time,” Ed Slott, publisher of IRAHelp.com, previously told CNBC Make It.
On top of that, cashing out your 401(k) means you’re essentially restarting your retirement saving journey. It may be difficult to build your funds back up to the level they were at previously.
Rather than tapping into your retirement savings, there are a couple of other options you can consider if you’ve experienced a layoff and need cash to cover day-to-day expenses.
Try a 0% interest credit card
While relying on credit cards shouldn’t be your first option either, if you don’t have emergency savings or another source of income readily available, you may want to temporarily use them to cover your living expenses, Lester says.
“If credit cards are the only way you’re going to be able to eat and you’ve cut out every single other expense then yes, put some stuff on a credit card,” she says. “But it’s not a strategy, it’s a desperation move.”
That’s because credit card debt can quickly balloon to an unmanageable amount due to high interest rates.
If you must rely on credit cards to cover your living expenses after being laid off, a card that offers a 0% interest period can help you avoid costly interest charges for sometimes up to 21 months.
But it’s important to note that not everyone qualifies for this type of credit card since you typically need a good to excellent credit score. Additionally, opening a new card may temporarily lower your credit score.
Apply for unemployment benefits
Another option is to see if you qualify for unemployment benefits in your state, Lester says.
Although each state uses a different set of rules to decide who qualifies for unemployment benefits, you’ll typically qualify if you were let go from your job due to no fault of your own, according to the U.S. Department of Labor.
You’ll need to file your claim with the state where you were employed and provide information such as your address and dates of your employment. It’s generally better to apply sooner rather than later since it can take a few weeks for you to receive a check.
“You want to file for that as soon as possible,” Lester says. “This is not the time to feel like ‘Oh, I can’t do that. That’s embarrassing.’ There’s no shame in getting laid off or getting unemployment benefits.”
It’s also important to note that the amount you receive will generally be based on a percentage of your earnings over the past 52-week period and capped at a state’s maximum amount, per the Labor Department. Additionally, you can receive unemployment benefits for a maximum of 26 weeks in most states.
For more information on eligibility guidelines, check out the Department of Labor’s unemployment insurance fact sheet and map of unemployment insurance offices.
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