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Your 401k withdrawal options are limited to what is written in your Summary plan document. Not all 401K plans allow loans so it is best to check what you can and can’t do first before you even consider a 401K withdrawal. The penalties are severe for taking a withdrawal from a 401k if you are under the age of 59 and a half. Let’s take an example. If you were 50 years old and took out $10,000. First you would pay federal income tax on 10% or $1,000 and if you lived in California, like I do, there would also be a state tax of 2.5% or $250.  Then there is the 10% penalty tax on top of that. That would be an additional $1,000. So your total expenses for that withdrawal would be $2,000 to $2,250, or in percentage terms 20%-22.50%. When you look at it like that, you can see that if you really needed the money, a cash advance on a credit card would be a less expensive choice to get cash and keep your 401k maximum account balance in tact.

Now if you are 55 and older and you leave your job or you are laid off, there are other 401k withdrawal rules . You can take one of three withdrawal options according to the IRS ruling 72T provisions. These options allow you to take a lump sum or a form of monthly income. Be careful how you decide because you are stuck with that decision until 5 years or age 59 and a half (whichever comes first).  This is a great backup plan for older employees in case their severance or unemployment benefits run out. The withdrawals are taxable which can be tricky since you would want to make sure there is some withholding on the payment stream so as to not get stuck with a large tax bill at the end of the year.

To get the 401k maximum balance, however, you still want to try to not touch that money and let it grow as much as possible. Many people watched their 401k balance shrink as fast as the economy did. Those people didn’t have a diversified portfolio or a risk ratio that they were comfortable with. Keep the money growing for the 401k maximum balance , but if you really need it review these options in detail with your fee-only financial advisor or Wealth Coach.  Remember, too, don’t tap your 401K withdrawal if you are unemployed, laid off or in debt. Consider filing bankruptcy as an option.

By Robert Powell, MarketWatch 

It might not be the bank of first or last resort, but it’s a bank nonetheless. About one in four investors borrow money from their 401(k), but, while such loans have some benefits compared to other sources of credit, they also can hit your retirement savings in unexpected ways.

About 22% of plan participants who are allowed to borrow from their 401(k) have such a loan at any given time and half had used a plan loan over a seven-year horizon, according to the authors of a just-published paper, “The Availability and Utilization of 401(k) Loans.”

The probability of having a loan follows a hump-shaped pattern with respect to age, job tenure, account balance, and salary, according to John Beshears, a professor at the Stanford Graduate School of Business, James J. Choi, a professor at the Yale School of Management, David Laibson, professor at Harvard University, and Brigitte C. Madrian, a professor at the John F. Kennedy School of Government at Harvard University, who co-authored the paper.

Those likeliest to have a 401(k) loan are plan participants in their 40s, with 10 to 20 years of tenure, earning $40,000 to $60,000, with $20,000 to $30,000 in their 401(k) plan. In 2008, the median amount of these loans was $4,000.

According to David Wray, the president of the Profit Sharing/401(k) Council of America and author of “Take Control with Your 401(k),” more recent studies suggest that one in four employees eligible for a loan have taken advantage of the option, with an average outstanding balance of $8,800.

Some borrow from their 401(k) to buy a home or for home improvements. Others to consolidate bills or pay off loans (sometimes the interest rate on a 401(k) loan is lower than other, more traditional sources of credit). And still others borrow to pay for education, medical bills, weddings, divorces and cars. But no matter the reason, experts say there are several things to consider before borrowing from your plan.

Not without advantages

According to Wray, there are two big advantages to a 401(k) loan. One, if your plan has a loan program, you have the security of knowing that your money is available “just in case,” Wray said.

“This means you can comfortably make the maximum contribution commitment to your plan without worrying if you might need those funds later,” he said.

And two, loans help prevent you from depleting your retirement savings when a financial crisis occurs. “If your plan offers loans, you will be required to take a loan first before you can take a distribution because once money is taken as a distribution, it cannot be replaced.”

Cheap source of credit

If you’ve already made up your mind to spend a certain amount and the only question is how you’re going to finance that spending, a 401(k) loan may be a reasonable source of financing, said Choi, a co-author of the report.

“A 401(k) loan will almost always be a better option than credit-card debt because the former’s interest rate is so much lower,” he said. The interest rate on 401(k) loans is usually the prime rate plus 1%, though rates vary from plan to plan.

Others agreed. According to Steve Utkus, a principal with the Vanguard Center for Retirement Research, 401(k) loans are a relatively cheap source of credit, compared, for example, to unsecured lines of credit or credit cards. Plus, there are no credit underwriting standards. “You are borrowing from yourself — and therein lies the rub,” Utkus said.

By law, the total outstanding principal of 401(k) loans can be no larger than 50% of a participant’s vested account balance or $50,000. The authors of the 401(k) study also note that participants are less likely to use loans in plans that charge a higher interest rate, and loans are smaller when plans allow fewer simultaneously outstanding loans, impose a shorter maximum possible loan duration, or charge a lower interest rate.

Besides being a source of cheap credit, Wray said there are other advantages to a 401(k) loan. There’s less paperwork to fill out as compared to other types of loans. There usually are no restrictions on how the proceeds are used. Most plans let you borrow for any reason. It’s fast.  You can receive a loan in mere days, depending on how often your plan processes transactions. And the rate of repayment for your loan may be greater than the rate of return you were receiving on your fixed investment.

Not a free loan

But cheap doesn’t mean free just because you’re borrowing from yourself, Choi said. “Your 401(k) loan interest payments face double taxation, since they are made with after-tax dollars and then get taxed again when you withdraw them in retirement,” said Choi. “And of course, whatever balances you spend now aren’t earning an investment return for you.”

Other experts share Choi’s point of view. “401(k) loans can be an important resource for participants facing financial hardship,” said Lori Lucas, a CFA charterholder, an executive vice president at Callan Associates, and chair of the Defined Contribution Institutional Investment Association’s research committee.

“The danger is when they are overused for non-essential purposes,” she said. “Participants pay back 401(k) loans with after-tax money. And, they become withdrawals if they go unpaid.”

Make sure your job is safe

Also, before taking a loan from your 401(k), consider how safe your job is. That’s because one of the dangers of a 401(k) loan is that if you leave your job or are laid off, you have to pay the loan off in full within a short period of time, usually 60 to 90 days, said Choi.

The greatest risk with loans is if they don’t get paid off, said Stacy Schaus, a senior vice president at PIMCO.

“Any balance you haven’t paid off at the end of that time is considered an early withdrawal, and if you’re younger than 59 ½, you’ll have to pay income tax on that amount plus an extra 10% tax penalty,” Schaus said. “Unless your job is very secure and you plan on staying with your employer for the duration of the loan, borrowing large amounts from your 401(k) is risky.”

Lucas agreed, and warned about a feature of some 401(k) plans. “While some plan sponsors allow repayment of plan loans after termination, most do not,” said Lucas. “Taxes and penalties can take a huge bite out of participants’ assets if the loan becomes a withdrawal. Further, withdrawn money is then forever lost to the retirement system.”

To be fair, the odds are high that you’ll repay the loan, according to Vanguard’s Utkus. According to his and other research, 90% of loans are repaid.

Still, one in 10 won’t repay their 401(k) loan, more often than not due to a job change. Since you don’t know whether you’ll be among the one in 10 who don’t pay back their loan or the nine in 10 who do, Utkus offered this advice: “If you anticipate changing jobs in the near term, I’d steer away from taking a loan, unless you have money outside the plan to pay off the loan when it becomes due.”

Other disadvantages

Dave Tolve, retirement business leader for Mercer’s U.S. outsourcing business, said borrowing from a 401(k) can have major consequences — even when repaid on time.

And plan participants should consider the advantages of not taking a loan. For instance, your money can keep growing. Plus, if you take money out of your account, even temporarily, you will miss out on valuable compounding and may end up with a significantly smaller nest egg by the time you retire. And, it is much easier to continue saving without the burden of a loan.

“Many people find it hard to continue making regular 401(k) contributions while repaying their loan — making it even harder to get back on the path to preparing for their retirement,” Tolve said.

Wray identified another disadvantage: 401(k) loans are not without fees. Some eight in 10 plans charge a one-time loan fee — of about $72 on average. Another 28% of plans charge an annual service fee of $35 on average. Plus, you may need to get your spouse’s permission for a loan.

Bottom line? “The long-term benefits of not touching your retirement savings may far outweigh the short-term benefits of taking the loan,” Tolve said. “Although it may seem easy to take a loan from your plan now, there may be other alternatives with lower interest rates that are available to you. Be sure to consider the impact a loan may have on your financial future and explore other options before you borrow from your plan.”

The study, “The Availability and Utilization of 401(k) Loans,” can be found at this National Bureau of Economic Research website.

Check your 401K plan summary plan description for 401K rules about taking a distribution while you are working.Your employer can tell you the 401k contribution limits, when you vest, and how much you can take out. Of course 401k rules only let you do this if you are past age 59.5 or the 401K penalties are severe. But if you need to supplement a reduced paycheck due to less work hours, then take small monthly amounts out to help you. Be prepared to pay the income tax on those distributions too.

Watch out for the number of hours that you work. At some companies if your work hours fall below 1,000 hours per year, then some 401K plans will eliminate matching contributions or prevent you from participating in the 401K plan. Check the 401K rules concerning this in your 401K plan. Your employer can tell you the 401k contribution limits

Before you get all excited about the possibility of taking money out of your 401K without penalty, consider these facts:

For a loan to not be treated as a taxable distribution it has to be repaid within 5 years

and it can’t exceed the lesser of $50,000 or

the greater of 1/2 of the nonforfeitable accrued benefit in the plan or

$10,000.

You must make level payments over the term of the loan and the level payments do not apply while you are on leave without pay for up to one year.

You MUST pay off the loan before you leave employment or else the unpaid portion is a taxable distribution and subject to the premature distribution penalty (if under age 591/2 ) or a taxable distribution if over age 591/2.

If you want the maximum balance in your 401K, try not to take out a loan but if you do, follow the tips above.

Everyone talks about doing a rollover of your 401K plan assets into an IRA and the wonderful advantages of that. Why do so many people do rollovers— because the receiving firm WANTS YOUR MONEY.

But there are some times when it is appropriate to just leave it with your ex-employer. Here are 4 criteria for staying in place:

• Your former employer allows you to keep your 401K plan.
• You like the variety of investment options and the performance of what you have.
• The investment options are low cost.
• There is no annual administration fee incurred for you to stay there.

For right now,  it usually is in your best interests to rollover since many people don’t get the 4 benefits above. I suspect that will change in the future when employers start to get better at picking 401k plans that are good for them and their employees.

When it comes to 401K withdrawals- just say no! Step away from the 401K account and find money somewhere else. You will find that taking money out have severe penalties — not just the 10% that you hear about but also federal income taxes and state income taxes too (depending on the state that you live in.  So don’t do it.

Here is an example: Sally lives in California and is 55 years old and takes $10,000 out of her 401k. Sally pays:

Federal 10% penalty tax-$1,000

CA state 2.5% penalty tax-$250

Federal income tax(28% bracket) $2200

State income tax (9% bracket) $1000

Do you think Sally made a wise decision?

Only spouses have been able to avoid a large tax bill when they inherit a 401K. The new tax law now allows non-spouses (children and other family members) opportunities to avoid taxes on inherited 401K money.

Typically the spouse is allowed to take the lump sum distribution from a 401K and roll it over to their own IRA where it can grow tax deferred. Tax deferral allows the money to grow fast. When the spouse turns 70 1/2 years old, he/she is required to take minimum distributions from the IRA. A lot of 401K plans don’t give non-spouse beneficiaries the same option. They are forced to take the money out of the 401k plan and pay taxes on the lump sum distribution all in one year.

Starting January 1, 2010, a new law that is part of the economic-recovery package Congress approved late last year, non-spouse beneficiaries will be able to rollover their lump sum distribution from a 401k that they inherited to their own Inherited IRA. An Inherited IRA will make the named non-spouse beneficiary take distributions stretched out over their lifetime. The tax bill will be a lot less than if they had to take the lump sum. It also helps the non-spouse beneficiary which is usually the children not blow through the money as fast as if they had all of it in one year.

A lot of problems can occur when the receiving custodian usually a bank or brokerage firm does not handle the paperwork for an Inherited IRA correctly. Obviously this is something they don’t do everyday and a lot of mistakes have been made where the money was rolled over into a personal IRA instead of an Inherited IRA. Make sure the firm you work with knows and understands how to do this or else it could cost you time and unexpected taxable income or penalties.

When inheriting the proceeds from a 401K, you can avoid a large tax bill. Follow the guidelines above to stretch the money over your lifetime in order to add to your financial plan and lower your tax liability.