Financial experts generally advise against borrowing from — and especially withdrawing early — from retirement accounts. And for good reason.
Betterment certified financial planner Garrett Oakley puts it this way: “A 30-year-old worker living in Illinois wants to cash out $14,000 from his 401(k). He’ll pay a 25 percent federal income tax based off his salary, a 10 percent early withdrawal penalty fee, and 3.75 percent state tax. So of that $14,000 he wants to borrow from his retirement account, he’ll only net $8,575. If he left it intact, and we assume an average 8 percent annual return, that would grow to over $150,000 by 65.”
“I tell my clients all the time that the 11th commandment is ‘thou shalt not touch thy retirement money,'” says Jeremy Torgerson, CEO of nVest Advisors in Brighton, Colorado. “But there are times when it’s unavoidable, so the question then becomes how to do it.”
When “life” happens, whether it is medical bills, college or another emergency, you may need to dip into those hard-saved funds. But before you do, consider the following and do so with caution.
[See: 7 Things That Can Derail Your Retirement Investing.]
You cannot borrow from your individual retirement account. “The IRA was designed stickily as a retirement savings vehicle. However the IRS does allow a 60-day rollover,” says Wayne Bland, a retirement consultant with Metro Retirement Plan Advisors in Charlotte, North Carolina. “In extreme cases if you had no other choice you could take a distribution from your IRA and if you pay (rollover) that amount back within 60 days it is not a taxable event.”
The IRS only allows this to occur once per calendar year, and if you do wind up having to pay taxes, it will be your ordinary income rate plus a 10 percent penalty if you are not 59.5 or older, Bland says. Once you hit 70.5 and take minimum distributions from the IRA, you’re not allowed to roll it back over.
Borrow from your 401(k), rather than withdraw, but only as last resort. Since early retirement withdrawals are taxed at ordinary income rates plus a 10 percent penalty, borrowing is a better option if you are in a pinch. Borrowing and repaying from a 401(k) is a tax-free event as long as you keep the payments up and don’t default, Torgerson says. The interest rate is usually lower than most other debt instruments and the repayment period is usually kept to no more than five years, he says.
Taking a 401(k) loan has its downsides, too, says Pamela Yellen, author of “The Bank on Yourself Revolution. “
“Just because you can take a premature withdrawal or a loan from your 401(k) doesn’t mean it’s a good deal,” Yellen says. “There are many strings attached to it, including how much you can borrow, what you can borrow it for, and how and when you must pay it back.”
“Generally, a participant’s ability to access 401(k) funds prior to retirement is restricted. A participant will not be able to withdraw funds from his or her account even in the event of hardship unless strict conditions are met,” says Glenn Sulzer, a senior analyst in corporate compliance with Wolters Kluwer Legal & Regulatory U.S. “However, neither the Internal Revenue Code nor ERISA restrict the purposes for which a participant may take a loan from the plan. The ease with which participants may access their accounts is a problem because of the potentially adverse effect such withdrawals could have on retirement savings.”
And if you leave your job for any reason, you’ll typically have to pay the loan back in full with interest within 60 days or you’ll owe taxes and penalties as if it was an early withdrawal, Yellen says.
[See: 8 Cheap ETFs to Build Your Nest Egg.]
There’s no limit on the number of a loans a participant can take if they meet dollar restrictions, Sulzer says. But you’ll want to be careful about doing this, since studies show that most workers who terminate employment default on outstanding 401(k) loans, Sulzer says. It results in about $1 billion in tax penalties and retirement plan leakage of about $74 billion. Also, 401(k) loans are not dischargeable in bankruptcy.
That’s also not to mention that loan interest payments are double taxed, since they are derived from after-tax salary and then again taxed when distributed as retirement benefits, Sulzer says.
Though you pay interest back to your account once borrowed, that interest may be lower than the rate of return that would have been earned on the account had the money remained invested, therefore losing critical gains in building wealth.
Consider why you need the money. If you need the retirement funds for a specific purpose, there may be a best option.
For example, you can use a once-per-lifetime, tax-free rollover from an IRA to a health savings account to pay for unexpected medical bills, Torgerson says.
You can also use Roth IRA contributions as an alternative college savings plan, an invested emergency fund, and an HSA.
Withdraw from a Roth IRA first. If you have multiple retirement investment vehicles available to you, start with the Roth IRA, Torgerson says, but only if your income still qualifies to contribute back to it.
Because these contributions have already been taxed, there are no tax penalties for withdrawals on principal — only earnings. If you don’t have a Roth IRA, then consider an IRA withdrawal, though it will be taxed as income. If you’re younger than 59.5, you’ll pay an additional 10 percent tax penalty for early withdrawal.
“Be sure to take out only exactly what is required,” Torgerson says.
[See: 12 Steps Toward a Stronger 401(k).]
“If you think you might need $20,000 out of an IRA but aren’t sure yet, it’s best to take out small withdrawals as often as you need them,” he says. “I tell clients to take as little as you can, as often as you have to, and that will reduce any overestimation on their part, which results in an excessive withdrawal and higher taxes.”
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Investors Should Not Tap Into Retirement Funds Early originally appeared on usnews.com
