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Think Twice Before Tapping Retirement Plans

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Before the housing crisis, it wasn't uncommon for people to raid their home-equity piggybank to pay off bills or buy things they couldn't otherwise afford. Plummeting home values and tougher lending standards helped curb that practice, leading some to engage in a far more disturbing habit: borrowing or withdrawing money from their retirement accounts to cope with financial hardship.

There may be critical times when a loan or withdrawal from an IRA, 401(k) or other tax-sheltered plan is your best or only option, but you should be aware of the possible impacts to 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 401(k) loans.

Loans usually must be repaid within five years, although the deadline may be extended if the loan is used 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.
  • It's not wise to take out a loan if you're planning to retire or change jobs in the next couple of years or if layoffs are a concern.
  • By carrying a monthly loan payment, you might be tempted to reduce your monthly 401(k) contribution amount, thereby significantly reducing your potential long-term account balance and earnings.
  • During the duration of loan repayment, your account value will be lower, which means you could be missing out on potential market upswings for the funds in which you're invested.

401(k) plan 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 -- and often the 10 percent penalty as well.

Unlike employer plans, with traditional IRAs you're allowed to withdraw from your account at any time for any reason. However, you will be subject to income tax on the withdrawal -- and usually the 10 percent penalty as well, except in certain hardship cases.

With Roth IRAs, you can withdraw contributions at any time, since they've already been taxed. However, if you withdraw the interest earnings before 59 ½, you'll likely face that 10 percent penalty.

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 tax implications. Note that with 401(k) and traditional IRA withdrawals, the money is added to your taxable income for the year, 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 7.5 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.

Losing compound earnings. Finally, if you borrow or withdraw your retirement savings, you'll lose out on the power of compounding, where interest earned on your savings is reinvested and in turn generates more earnings. You'll lose out on 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: Think long and hard before tapping your retirement savings for anything other than retirement itself. If that's your only recourse, be sure to 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.

To participate in a free, online Financial Literacy and Education Summit on April 4, 2011, go to Practical Money Skills.