Alternatives to Borrowing from Retirement Accounts

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The following is presented for informational purposes only.

Most of us know that retirement funds are for just that: retirement. It's money we're saving up to use and enjoy once we've retired and stopped earning a regular income.

And we also know that it's generally not a good idea to dip into those retirement funds before you're eligible. Unfortunately, circumstances sometimes require us to access our retirement savings early, despite the many penalties we can incur. For many Americans, those unfortunate circumstances are cropping up much more frequently in recent years.

A record number of Americans were forced to make early withdrawals from their 401(k)s in 2023, topping the previous high set way back in...2022. 

Inflation and stagnant wages continue to make it difficult for families to build savings, leading to increasing numbers dipping into their retirement funds to navigate financial emergencies. With these numbers on the rise, let's take a look at why so many are being forced to access their retirement money early, the potential consequences, and the available alternatives.

Top reasons for borrowing from retirement

Nearly 40% of the Americans who made early withdrawals from their 401(k) in 2023 did so to help prevent a foreclosure. Ultimately, the majority of people who borrow from their retirement funds do so to help finance some kind of emergency expense.

  • Home repairs
  • Medical expenses
  • Legal expenses

These emergency situations are the most understandable reasons for tapping your retirement funds. Other reasons may include:

  • Bridge financing a short-term cash flow need (a few months at most) 
  • Consolidating high-interest debt if the potential savings is greater than the potential cost of withdrawing funds early
  • Investment opportunities where the return is likely to exceed the cost

Withdrawing retirement funds for any reason is inherently risky, so it's highly recommended that you don't do it unless you fully understand the risks or feel that it's the only viable option.

Consequences for making an early withdrawal

You may already know that borrowing from your retirement accounts is bad, but what are the potential ramifications?

Income taxes

The withdrawn amount is typically subject to income tax in the year it's withdrawn. This can significantly reduce the amount you receive from the withdrawal.

Early withdrawal penalties

If you withdraw funds from a retirement account before reaching age 59½, you may be subject to an additional 10% early withdrawal penalty on top of the regular income tax unless you qualify for an exception.

Depending on the type of retirement account and the reason for the withdrawal, there may be additional taxes or penalties imposed by the IRS or state tax authorities.

Lost future growth

For accounts where taxes are deferred, 100% of your growth is compounded, which helps your account grow rapidly. Withdraw early, however, and withdrawn amount loses the opportunity for tax-deferred growth. Even if you repay the withdrawn amount later, you will forever have lost the amount that money could have grown while it was in the account.

Loss of protection

Retirement accounts often have some level of protection from creditors, preventing them from being access if you get sued by a creditor for example. If you withdraw funds and keep them outside of a retirement account, they may be more vulnerable to creditors in the event of bankruptcy or legal action.

Can you ever make an early withdrawal without penalty?

There are some specific instances where you may be able to access retirement funds early and not incur a financial penalty. It's a good idea to work with a professional to determine if you're eligible for any of the following:

  • Qualified distributions: Roth IRA contributions can be withdrawn at any time without penalty, as they are made with after-tax dollars. Additionally, qualified distributions from a Roth IRA (those made after age 59½ and held for at least five years) are not subject to penalties or taxes.
  • Disability: If you become permanently disabled, you may be able to withdraw funds from your retirement account without penalty.
  • Medical expenses: You may be able to withdraw funds without penalty to cover medical expenses that exceed a certain percentage of your adjusted gross income (AGI).
  • First-time home purchase: You may be able to withdraw up to $10,000 from an IRA penalty-free to purchase a first home, provided certain conditions are met.
  • IRS levy: If the IRS levies your retirement account to satisfy a tax debt, the amount withdrawn is not subject to the early withdrawal penalty.
  • Substantially Equal Periodic Payments (SEPP): You can set up a series of substantially equal periodic payments from your IRA or other qualified retirement plan and avoid the early withdrawal penalty, provided that you adhere to IRS guidelines.
  • Military service: Active-duty military reservists may be eligible to make penalty-free withdrawals from their retirement accounts under certain circumstances.

Alternatives to borrowing from your retirement

If you're thinking of dipping into your retirement funds early, there's probably a pretty good reason. You may legitimately not have any alternative, and if that's the case then you should do what you need to do. Otherwise, if you're dealing with a financial problem and considering tapping your 401(k) as a solution, consider these other options first.

Emergency fund

The first resort should always be to use your savings. Unfortunately, too many families aren't in a position to build an adequate emergency savings account, so this may not be an option for many. 

Home equity loan

If you own a home, you may be able to tap into your home equity through a home equity loan or line of credit (HELOC) to cover expenses. However, be cautious, as using your home as collateral puts it at risk if you're unable to repay the loan.

Personal loans

Consider applying for a personal loan from a bank or credit union to cover short-term financial needs. Personal loans typically have fixed repayment terms and may offer lower interest rates compared to credit cards or payday loans.

Credit cards

A credit card with a bad interest rate can be costly way to solve one problem (while creating another). That said, credit card debt is preferable to jeopardizing your retirement.

Side income

Sometimes the best answer to too many expenses is to generate more income. That's not a small thing to do, but luckily our current economy is optimized for short-term side hustles that can help supplement your regular income.

Work with a financial expert

Consider seeking advice from a certified financial advisor or a nonprofit financial counselor who can help you assess your financial situation and explore alternative solutions to early withdrawal from retirement accounts.

Whatever path you take, if you're struggling it's important that you take steps as soon as possible. If you need help with overwhelming expenses, MMI free financial counseling 24/7, online and over the phone.

Tagged in Retirement, Managing a loss of income, Investing

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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