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!
Understand the Penalties
Taking a distribution from your 401(k) or IRA before you turn 59 and a half will result in a 10% penalty on the funds unless it qualifies for an exemption. This penalty 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 you are in a 25% income tax bracket, 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. Since you are retired, your tax rate went from 25% to 15%, so 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.
Most 401(k)s will allow you to take a distribution under certain “hardship” scenarios. IRAs allows you to take money for qualified higher education expenses and unreimbursed medical expenses. You can also pull $10,000 out for a first-time home purchase. (Note: Your spouse can do the same!)
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). You can take out a maximum of $50,000 or half your 401(k), whichever is less. 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 or are fired, you’ll be expected to pay the entirety of the loan back, usually within 60 to 90 days!
Here at WIFE, we understand that financial emergencies happen, but taking early distributions from your retirement should always be considered a last resort! Need help getting back on financial track? Consider starting a Money Club!