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.
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.
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.
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.
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I'm just an average mom, trying to live a frugal life and get out of debt. I write about things that have (and haven't) worked to improve my family's financial situation. What works for me may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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