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Resist the Urge to Tap Retirement Plans Early

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I have yet to meet anyone who thinks they're saving too much money for retirement. On the contrary, most people admit they're probably setting aside too little. Retirement accounts must compete with daily expenses, saving up for a home, college and unexpected emergencies for every precious dollar.

Financial experts agree that tapping your retirement savings early should be a last resort. But if taking money out of your IRA, 401(k) or other tax-sheltered plan is your best or only option, you should be aware of the possible impacts on your taxes and long-term savings objectives before raiding your nest egg:

401(k) loans. Many 401(k) plans allow participants to borrow from their account to buy a home, pay for education or medical expenses, or to prevent eviction or mortgage default. Generally, you may be allowed to borrow up to half your vested account balance up to a maximum of $50,000 -- or a reduced amount if you have other outstanding plan loans.

Loans usually must be repaid within five years, although you may have longer if you're using the loan to purchase your primary residence.

Potential drawbacks to 401(k) loans include:
  • If you leave your job, even involuntarily, you must pay off the loan immediately (usually within 30 to 90 days) or you'll owe income tax on the remainder -- as well as a 10 percent early distribution penalty if you're under age 59 ½.
  • Loans cannot be rolled over into a new account.
  • Some plans don't allow new contributions until outstanding loans are repaid.
  • It's not wise to take out a loan if you're planning to retire or change jobs in the next few years -- or if you're concerned about layoffs.
  • Many people, faced with a monthly loan payment, reduce their 401(k) contributions, thereby significantly reducing their potential long-term account balance and earnings.
  • Your account value will be lower while repaying your loan, which means you'll miss out on market upswings for the funds in which you're invested.

401(k) and IRA withdrawals. Many 401(k) plans allow hardship withdrawals to pay for certain medical or higher education expenses, funerals, buying or repairing your home or to prevent eviction or foreclosure. You'll owe income tax on the withdrawal -- plus an additional 10 percent penalty if you're younger than 59 ½, in most cases.

Traditional IRAs allow withdrawals at any time for any reason. However, you'll have to pay income tax on the withdrawal -- and usually the 10 percent penalty as well, with certain exceptions. With Roth IRAs, you can withdraw contributions at any time, since they've already been taxed. However, to withdraw earnings without penalty you must be at least 59 ½ and the funds must have been in the account for at least five years.

To learn more about how the IRS treats 401(k) loans and withdrawals, read this Resource Guide. For more on IRA treatment, read IRS Publication 590.

Further financial implications. With 401(k) and traditional IRA withdrawals, the money is added to your taxable income, which could bump you into a higher tax bracket or even jeopardize certain tax credits, deductions and exemptions that are tied to your adjusted gross income (AGI).

For example, if you itemize deductions, you can only deduct miscellaneous expenses (such as unreimbursed employment expenses and tax preparation fees) that exceed 2 percent of your AGI; so the higher your AGI, the higher that threshold. The same goes for medical expenses, which must exceed 10 percent of AGI before being deductible.

All told, you could end up paying half or more of your withdrawal in taxes, penalties and lost or reduced tax benefits.

Other potential wrinkles:
  • If you're planning to use a 401(k) or IRA withdrawal to pay for your children's college costs, keep in mind that it counts as income so it could reduce the amount of financial aid for which they qualify in future years.
  • Money in 401(k) and IRA accounts generally is safe from creditors. But if your reason for withdrawing money were to stave off bankruptcy, if you later went bankrupt you'd lose all those withdrawn retirement savings.

Losing compound earnings. Finally, if you borrow or withdraw your retirement savings, you'll sacrifice the power of compounding, where interest earned on your savings is reinvested and in turn generates more earnings. You'll forfeit any gains those funds would have earned for you, which over a couple of decades could add up to tens or hundreds of thousands of dollars in lost income.

Here's an example: Suppose you're 30 years from retirement, earn $50,000 a year, and contribute 8 percent of pay to your 401(k) with a 50 percent employer match on the first 3 percent of pay. If you withdraw $10,000 (and your plan suspends contributions for six months -- a common feature), the net impact is that you would have $128,299 less in future retirement benefits, according to this interactive calculator at CalcXML.com. The same site also has calculators for the impact of increasing your 401(k) contribution, the impact of borrowing from your account, and many more.

Bottom line: Carefully consider the potential downsides before tapping your retirement savings for anything other than retirement itself. If that's your only recourse, consult a financial professional about the tax implications; if you don't know one, the Financial Planning Association is a good place to start your search.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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