Most of us will face a financial emergency at least some time in our life. Maybe your car broke down, and the repair bill makes your savings account cry. Maybe you’ve got a baby on the way and it’s finally time to buy your first home. Perhaps divorce reared its ugly head and you’ve got to pick yourself up with far less income than you are used to (and with attorney bills piling up). Whatever the reason, when you need money, it’s natural to turn to your 401(k) or IRA. It may seem like your retirement account is the perfect piggy bank, but take a moment to truly consider if taking money from your account is a good idea. You could be shortchanging your future!
As always, remember that the information on this website is for general educational purposes only and not intended to provide specific advice or recommendations. Please discuss your particular circumstances with an appropriate professional before taking action.
Understand the Penalties
Taking a distribution from your 401(k) or IRA before you turn 59½ may result in a 10% additional tax unless an exception applies. This comes on top of the taxes you’ll pay when the money comes out.
If you desperately need money, like right now, penalties and taxes might not change your opinion, but consider that you aren’t just paying these upfront penalties. You are also losing any potential gains that money could have made for you as it grew in your retirement account.
For example, let’s say that you are 35 years old and pull $20,000 out of your IRA. You’ll face a 10% penalty fee which will immediately shave $2,000 off the amount. If your marginal federal (and state, if applicable) income tax rate is 25%, you’ll lose another $5,000, leaving you with only $13,000.
Now, consider what would happen if you kept that $20,000 in your retirement portfolio and enjoyed an average 7% return each year. By the time you turned 65, that $20,000 would have turned into $114,869. If your marginal tax rate in retirement is lower (for example, 15%), then when you pull the money out, it will be worth over $97,600.
That is a HUGE difference and should give you pause if you are thinking of pulling money out of your 401(k) or IRA!
Take Advantage of Exemptions
If you absolutely must pull money out of your retirement accounts, try to take advantage of an exemption, which will at least allow you to avoid the 10% penalty.
Many 401(k) plans may permit hardship withdrawals under plan rules and IRS guidelines, but hardship approval does not automatically mean the 10% additional tax is waived. IRAs allow penalty exceptions for certain qualified expenses, including qualified higher-education expenses and some unreimbursed medical expenses (subject to IRS rules/limits). You can also withdraw up to $10,000 (lifetime limit) from an IRA for certain first-time home purchase costs (subject to IRS rules). If both spouses qualify, each may have their own $10,000 lifetime IRA limit.
Borrow Against Your 401(k)
Probably your best distribution option, especially if you don’t meet the requirements for an exemption is to take out a loan from your 401(k). Generally, the maximum 401(k) loan is the lesser of $50,000 or 50% of your vested balance. Some plans may allow up to $10,000 even if 50% of your vested balance is less than $10,000, and existing loans can reduce how much you can borrow. The beauty of the loan is that you pay yourself back with interest, so your retirement savings can continue to grow.
Borrowing against your 401(k) can be tricky. Your employer must agree to let you take out the loan and then must administer the loan. Also, if you leave your job, your plan may require repayment quickly to avoid default. If the loan is offset (treated as distributed), you may be able to avoid taxes and the 10% additional tax by rolling over the offset amount by your tax return due date (including extensions) for the year of the offset.
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