IRAs and employer-provided retirement plans are designed to promote long term retirement savings. The benefits include attractive tax-deferral savings and accumulation of earnings. The costs do not begin until you pay taxes on the distributions, or face penalties on early withdrawals. However, at some point, you may be tempted to use a retirement plan for immediate financial needs. Before you decide what to do, you need to consider the potentially high costs of your choice.
The Cost of Withdrawals
Withdrawal rules are different for IRAs and qualified plans, such as 401(k) plans. Generally, you can withdraw funds from an IRA for any reason, as long as you are prepared to pay the taxes and penalties. Some withdrawals are penalty-free, including those used for health insurance (if you are unemployed), the purchase of a first home and the extraordinary expenses needed to pay for college tuition, disability-related costs and deductible medical expenses.
Withdrawals from qualified plans are generally not permitted before you retire, die or become disabled. However, some plans permit in-service withdrawals for employees who reach 59½ or normal retirement age, or hardship withdrawals for certain expenses. These withdrawals usually are taxable income and subject to a 10% penalty if you withdraw funds under the age of 59½.
You should also consider the loss of tax-deferred growth on any withdrawn funds. For example, if you have $100,000 in your company's 401(k) plan, contribute $15,000 per year to the plan, and have 15 years until retirement, you have a big incentive to leave the funds in your account. It will grow to almost $670,000 (assuming a 7% rate of return) at retirement. After retirement, you may benefit to withdraw funds in a lower income tax bracket than you currently are taxed. However, if you withdraw $30,000 from your plan account to pay your child's college expenses, you will owe income taxes and penalties on that amount now and reduce your retirement savings by more than $80,000 over the same 15-year period.
The Option of Taking Loans
Some qualified plans permit loans of up to half of the vested account balance (up to $50,000). With such plans, borrowing may appear to be a "free" option, since there are no income taxes or penalties and you pay the loan interest to yourself.
Nevertheless, any amount you borrow you may reduce your account's future potential growth. The loan interest you pay generally will not be deductible. Also, you may lose the ability to make contributions or receive matching contributions during the term of the loan. Finally, if you lose or quit your job, you will have to repay the loan immediately or owe income taxes and penalties.
Other Options May Be Less Costly
In most cases, taking an early withdrawal or loan from your retirement account will have long-term consequences on your retirement savings. Since it is difficult to fully assess the long-term costs of a short-term need, most retirement plan assets should be regarded only as a last resort. So, you may want to consider other options, such as borrowing from a bank or family member, and avoid the quick decision to take funds out of your long term retirement savings.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
