Think Twice Before Taking Money from Your Retirement Account

When you start adding up your assets, it’s common to include your retirement accounts. After all, the money that you have in these accounts contributes to your overall net worth. At the same time, though, when you run into a little financial trouble, it’s tempting to turn to your retirement account and withdraw money to shore up your finances. Before you decide to withdraw money, though, think twice. Tapping into your retirement account should be the last resort.

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Penalties and Taxes

The money you put into your retirement account comes with tax advantages. It is also understood that you agree to use that money for retirement, after you turn 59 1/2. If you withdraw money before that age, you could be hit with penalties. First of all, you are assessed a 10% penalty for withdrawing your money early.

Next, you have to pay taxes. When you put money in a traditional IRA or a standard 401(k) account, you receive a tax deduction. Your tax payments are deferred. Once withdraw the money, though, you have to pay taxes on it. You pay taxes on the amount of your withdrawal at your marginal income tax rate.

There are exceptions to the penalties if you have certain types of retirement accounts. There are some instances in which you can draw money without penalty from an IRA. And you can withdraw any of your contributions to a Roth IRA at any time without worrying about taxes or penalties. Since you contribute after tax dollars to your Roth IRA, you don’t have to pay taxes on your withdrawals. And, as long as you stick to what you have actually contributed, and you don’t withdraw any of your earnings, you don’t have to worry about penalties.

What about Loans?

One way you can avoid the penalties and taxes is to take out a loan against your retirement account. If your employer allows loans against your 401(k) (not all employers do), you can borrow money from yourself. You have to pay interest, but you are paying it to yourself. You might also have to pay a loan origination fee. However, it can be less than what you would pay in penalties and taxes.

When you take out a loan from your retirement account, you have to make sure you pay as agreed. If you don’t repay the money in the prescribed time period, you will be hit with penalties and taxes. You also have to be aware of the fact that if you leave your job before the loan is paid, you have to repay it quickly — no matter the term — or face the penalties and taxes.

If you have no other choice, a loan from your retirement account might not be the end of the world. You are better off having an emergency fund, and turning to friends and family. But if you are out of options, borrowing from yourself can be one way to stave off your financial catastrophe while limiting your costs.

Missed Opportunity

The biggest reason to avoid tapping into your retirement account before you retire, though, is the missed opportunity. If you take money out of your retirement account, it’s no longer sitting there, earning compound interest. Part of the reason that a consistent retirement savings plan is so powerful is due to the magic of compound interest.

Your capital sits there, making money on your behalf. Once you pull that capital, it is no longer earning interest. It isn’t working for you. Even if you put the money back in later, there is no recovering the lost time. If you take a loan from your retirement account, and take five years to repay it, you can really lose a lot of potential gains. If you don’t repay the withdrawal, than that money — and the future money it would have earned — is gone completely. Plus you have the added costs of penalties and taxes. That’s a lot of missed opportunity for the future.

Before you take money out of your retirement account, stop and think about the consequences of your actions. Think about the costs, and calculate whether or not it’s worth. It just might not be.

Photo by Sugar Sweet Sunshine.



Author

By , on Dec 16, 2012
Miranda Marquit Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.

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{3 Comments}

  1. There is a hidden cost in taking out loans from a 401K that most people miss: they are borrowing against pre tax contributions, but repaying the loan with after tax dollars.

    For example, someone borrows $1,000 from a 401K funded with pre tax dollars. That person needed to earn $1,000 to make that contribution.

    In repaying the loan after tax dollars are used. If the person pays 35% in total taxes (federal, FICA, and state income), he/she would have to earn $1,538 to get $1,000 in after tax money. ($1,000/65% = $1,538)

    That equates to 54% borrowing cost before interest and loan origination charges.

  2. It’s almost never a good idea to take money from a retirement account. It may seem like borrowing from yourself, but you are paying a hefty fee in “penalties” to the company with which your retirement account is housed. Plus, you are missing out on valuable interest-gaining opportunities if you take money from such an account.

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