The following is presented for informational purposes only.
Your retirement fund has a single job — provide you with money after you stop working. But when an emergency strikes, you may be tempted to withdraw or borrow funds from an IRA or 401(k).
While many people will advise you to never dip into retirement funds early, the reality is that you may have an immediate need and few choices. Rather than drawing a hard-line rule, learn how withdrawals and loans work so you can make an educated decision for yourself.
Why Shouldn’t You Withdraw Money From Retirement Accounts?
Retirement accounts are special because you’ve earmarked the money for retirement, a period when you likely won’t have much income and will need the savings. They also offer tax-advantages that can significantly increase how much money you’ll be able to accumulate over time.
Taking money out of the account can lead to several negative consequences:
- You might increase your taxable income: If you’ve contributed to a pre-tax or “traditional” retirement account, you likely received a tax deduction for your contributions. When you withdraw the funds, you have to include the money in your taxable income for the year, which can increase how much you owe come tax time. This is true even when you withdraw money during retirement, but you may pay less tax then if you have less income for the year.
- You may pay additional penalties: Qualified retirement accounts, such as 401(k)s, 403(b)s, and IRAs may charge an early withdrawal fee of 10% if you don’t qualify for an exemption. The fee increases to 25% for SIMPLE IRAs if it’s been less than two years since opening your account. The fee is in addition to the income taxes you may pay on withdrawals.
- You miss out on future growth: While you won’t feel the pain right away, withdrawing your money now means you’re stopping its growth. You can use an online calculator to estimate how much an early withdrawal will cost you in terms of taxes, penalties, and lost growth.
- You may lose protections from creditors: In some cases, creditors can’t go after your money if it’s in a qualified retirement account. Your 401(k) balances and over $1.1M in IRA accounts may even be exempt if you declare bankruptcy. However, creditors may be able to go after the money if you withdraw it from your qualified account.
You can’t avoid including withdrawals as taxable income unless you used a Roth IRA or Roth 401(k), in which case, you already paid income tax on the contributions. However, you may be able to avoid the early withdrawal penalty. And, if you borrow from your account rather than completely withdraw the funds, you might limit the overall impact.
How To Avoid Early Withdrawal Penalties
You won’t pay early withdrawal penalties once you’re 59½ years old. Even before that point, there are certain situations when you can qualify for an exception.
For example, you may be able to take a penalty-free withdrawal if you become totally and permanently disabled or if you use the money for unreimbursed medical expenses that are over 10% of your adjusted gross income.
These exemptions also vary depending on whether you have an IRA or a 401(k) or 403(b). With IRAs, you can take an early withdrawal to pay for health insurance premiums while you’re unemployed. You can also withdraw up to $10,000 to buy a home if you haven’t owned a home in the previous two years. But those two exemptions don’t apply to 401(k)s and 403(b)s.
The IRS website has a complete list of exemptions.
You May Be Able To Take a Loan Instead of an Early Withdrawal
Another way to avoid an early withdrawal penalty is to take out a loan rather than withdraw the money. Loans aren’t available with IRAs, although there’s a workaround to take money out for 60 days, and are only sometimes available with other qualified retirement plans.
If your retirement plan sponsor allows loans, they can offer several benefits over other types of loans:
- There’s no credit check to qualify
- It won’t show up on your credit report
- The loan won’t count as income
- The IRS allows you to borrow up to $50,000, although some plans may have lower limits
- You’re paying interest to yourself
- You may be able to repay the loan over a five-year period (or longer, if you use the money to buy a primary residence)
It’s not all good news, though. Taking money out of your retirement plan means you’ll still miss out on potential growth during that period. Plus, if you need the money when the market is down, you’ll be “selling low” and may wind up rebuying your investments at a higher price later.
Also, if you’re unable to repay the loan, the money could be considered an early withdrawal and you may have to pay income taxes and a penalty. And if you lose or leave your job while repaying the loan, you may have to repay the remaining balance by the due date of your next annual tax return.
So, When Is It a Good Idea?
As with everything tax- and finance-related, there are fine-print details that may impact your specific situation. But now that you know the basics pros and cons of taking early withdrawals or retirement account loans, you can make a more informed decision.
Yes, there are drawbacks to taking money out of a retirement fund. However, it may be an okay option when:
- You’ve lost your job and need money for basic necessities.
- You may otherwise lose valuable assets, such as your primary residence or vehicle.
- You can use the funds to pay off high-interest debt.
Even so, you don’t want to jeopardize your future if you can avoid it. Many people struggle with finances during a large crisis, such as the coronavirus pandemic. However, creditors may also be willing to work with you to offer lower payments or temporarily pause payments.
You can also schedule a free consultation with a trained credit counselor to discuss your situation. The counselor can help you understand your options, discuss the pros and cons of each, and may share solutions that you hadn’t considered.