401k In-Service Withdrawal: Good Idea or Bad?

I recently ran into a situation where an employee withdrew money from their 401k in order to buy a home that he had been renting.  Certainly, owning a home is part of the American dream, but is it a good idea to use your retirement savings?  In this case, he took an ‘in-service withdrawal’ instead of a loan.  Some employers allow this if you’re over a certain age, typically age 59½.  Generally, withdrawals prior to age 59½ result in a federal 10% early-withdrawal penalty.

The reason he didn’t do it as a loan is that under current rules 401k loans are limited to $50,000 and must be repaid through payroll deductions, thereby reducing his take-home pay.

Perhaps the obvious downside of an in-service withdrawal is that all the proceeds will be added to his current income for income tax purposes and therefore taxed at his highest marginal tax rate…or worse, the withdrawal will almost certainly throw him into a higher marginal tax rate.

Had he waited until retirement and made periodic withdrawals for retirement income, withdrawals would most likely be taxed at a significantly lower income tax rate.

For these reasons, an in-service withdrawal is not generally recommended and should only be used as a last resort or in emergency situations.  It just costs too much money.  In this case, he decided owning a home was worth it.