Why You Shouldn't Tap Your Retirement Fund
The cons for taking money from your retirement account far outweigh the pros, and it's best to find other sources to ease your financial burden.
According to a recent Pew Charitable Trusts report, roughly 13 percent of people with retirement accounts indicated that they had drawn on the accounts the previous year and had experienced a "financial shock" during the same period.1 Another 2 percent said they made withdrawals even without experiencing financial shock.
When you're strapped for cash, you look at any option within your grasp to make ends meet. Most people have been in this situation at one time or another, and it can be an extremely stressful and even desperate experience. If you have a retirement fund – either an IRA or 401(k) – it can be tempting to tap it to help you through your difficult financial time. After all, this is your money and it's there. Why not use it when you really need it? Unfortunately, it's not that simple. The cons for taking money from your retirement account far outweigh the pros, and it's best to find other sources to ease your financial burden.
If you have no other options than to turn to your IRA or 401(k), there are still options that are better than others. Let's look at withdrawing from your retirement fund versus borrowing from it.
Pros and cons of withdrawing from retirement
There really aren't many pros to withdrawing from your retirement fund outside of the obvious. You have access to money. While this is certainly the desired solution on the surface, that access does not come without a cost.
For starters, the more you withdraw, the less you'll have in the account for retirement. You’re forgoing the value of compound interest on your principal. You will also be penalized for early withdrawal. This is generally 10 percent, plus taxes that may need to be paid – another con. Here's what the IRS has to say about early withdrawal:2
Many people find it necessary to take out money early from their IRA or retirement plan. Doing so, however, can trigger an additional tax on top of income tax taxpayers may have to pay. Here are a few key points to know about taking an early distribution:
Early Withdrawals. An early withdrawal normally is taking cash out of a retirement plan before the taxpayer is 59½ years old.
Additional Tax. If a taxpayer took an early withdrawal from a plan last year, they must report it to the IRS. They may have to pay income tax on the amount taken out. If it was an early withdrawal, they may have to pay an additional 10 percent tax
Nontaxable Withdrawals. The additional 10 percent tax does not apply to nontaxable withdrawals. These include withdrawals of contributions that taxpayers paid tax on before they put them into the plan. A rollover is a form of nontaxable withdrawal. A rollover occurs when people take cash or other assets from one plan and put the money in another plan. They normally have 60 days to complete a rollover to make it tax-free.
The IRS also notes that there are many exceptions to the additional 10 percent tax and that some of the rules for certain retirement plans are different from the rules for IRAs.
This article from U.S. News3 lists 11 ways to avoid the IRA early withdrawal penalty. This includes a first home purchase, medical expenses, a disability, and other situations.
Pros and cons of borrowing from retirement
If you've made up your mind to tap your retirement account for funds to help you out in the short-term, simply withdrawing is not the only option. You also have the option to borrow from it. This comes with its own set of pros and cons.
On the positive side, you'll be able to quickly access the money you need, and assuming you pay it back, that money will be there for your retirement. You're essentially taking a loan out from yourself, so that means you don’t need to apply for a loan and get a credit check. You also won't face penalties and taxes on the money like when you withdraw early, since you're making a commitment to pay the money back to your account. Another plus is that the interest you pay goes to your own account. There are also likely low or no application fees.
On the negative side, you have a new bill to pay, which can add to your longer-term financial woes. You may also face borrowing limits and length restrictions requiring you to pay the money back more quickly than you'd like to, or are even able. Your repayments are also made with after-tax money, so you're losing money that way. All the while, your investments won't grow the way they would have if you hadn’t borrowed money from your retirement fund.
Look for an alternative
While borrowing from your retirement account has its pros and cons, a better option might be to take out a bank loan or even a home equity credit line to help you consolidate some of your debt and get a lower interest rate. This may ease some of your financial burden in a way that won't impact your all-important retirement fund.
The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice. Any views expressed in this article may not necessarily be those of Nevada State Bank, a division of ZB, N.A. Member FDIC