Why You Should Do Everything You Can to Avoid Early Withdrawals from Your Retirement Account – Guest Post
Losing your job is scary. The job market is recovering slowly, but as any unemployed person can tell you, there’s still no telling when you might get a call for an interview, much less a job offer.
It’s understandable then, why so many people resort to raiding their IRA and other retirement accounts when they lose their job. In such uncertain economic times, people want the security of knowing that they will make it — and at the end of the day, they think, “what good is a retirement fund if I’m too broke to ever retire?”
But prematurely withdrawing funds from your retirement account is bad news and has serious consequences, whether you need it or not. Sometimes it’s essential to withdraw the money — that’s why they call it a hardship withdrawal — but if you do have to take money out, be sure you understand the implications:
The Price of an Emergency
Kevin O’Fee, vice president of retirement strategy at USAA bank, says “the IRS makes early withdrawals onerous because it wants to encourage keeping money in the plan for retirement — its intended purpose.” And he’s right.
Withdrawing money from a 401(k), a 403(b), or a Thrift Savings Plan before the age of 59½ will result in a 10% penalty, and all the funds you withdraw are considered taxable income. Let’s break that down a little.
If you had a $10,000 emergency, for example, that forced you to withdraw funds from your retirement account, depending on the state you lived in, you might only get $6,000 of that money, after the penalty and taxed.
“You don’t just lose the long-term accumulation effect of having the money in your account,” says David Wray, president of the Profit Sharing/401(k) Council of America. “The value of the amount you withdraw takes a big hit.”
Generally retirement accounts offer two ways to withdraw funds in an emergency: loans and hardship withdrawals. Both have their advantages and disadvantages, but if you have to pick one, it’s better to borrow from your 401(k) than to make a withdrawal.
Obviously you want to avoid taking money out at all, but as certified financial planner June Walbert says, if you take out a hardship withdrawal, “you’ll be robbing your future for a need today and paying a dear price.”
Walbert continued, saying, “Borrowing from a 401(k) gives you flexibility. As long as you can meet the requirements of paying it back, you may be better off taking out a loan than taking a permanent withdrawal of funds from the account.”
• Low interest rates. Wray says that interest rates for 401(k) loans are extremely reasonable, typically the prime interest rate plus 1%.
• You might be able to continue making contributions. Not all companies offer this, but some allow employees to contribute to their retirement accounts even though they’ve taken a loan out against them. If you withdraw funds, however, the IRS prohibits you from contributing for six months.
• You can pay yourself back. “Loans get repaid,” Wray notes. “You’re not subject to all the taxes and penalties of a withdrawal, which never gets repaid.”
• You’ll have even more debt than you did when you took out the loan, and you will have to pay it back within one to five years.
• Failing to repay the loan will transform the loan into a permanent withdrawal, and the IRS will take out taxes and possible a 10% penalty.
• If you quit your job you will have to pay the remainder of the loan back as a lump sum. And guess what happens if you can’t afford it? You now have a permanent withdrawal with taxes taken out and, again, possibly a 10% penalty.
Employers and the IRS really don’t want you to take money out of your retirement account, and in some cases, company policy won’t even allow it. If your company does, you will also have to meet IRS requirements that include showing “an immediate and heavy financial burden.” Then and only then will you be eligible to withdraw funds, which will be taxed, along with (you guessed it) the 10% penalty.
“Withdrawals should be used only in truly the most extreme cases,” says Wray. If you have absolutely no other way to pay for an emergency, then consider taking out funds, but know that the IRS only lets you take exactly what you need and nothing more.