Dipping into a retirement account early is rarely an investor's Plan A. However, there may come a time when a person desperately needs money and has no other options left. In certain circumstances, drawing on a 401(k) or IRA may be the only right choice.
Certainly, the IRS does not make it easy to create these tax-deferred accounts. Even if you qualify for a so-called hardship withdrawal, you will be charged an additional 10% penalty on any funds you withdraw from a traditional 401 (k) or IRA account before age 59 ½. It's the ordinary income tax rate you normally pay on distributions. This fairly strong disincentive is designed to discourage Americans from withdrawing their funds early.
There is one exception: you can get the after-tax money you put into a Roth IRA without a 10% penalty, as long as you are careful to withdraw only the amount you put in, not any earnings it made. For more information, see Using your Roth IRA as an emergency fund .
But even with 401(k) accounts and traditional IRAs, the tax code offers some ways to avoid the 10% early distribution fee. Granted, the decision to use that money for something other than your retirement shouldn't be taken lightly. But if you can avoid the IRS penalty, the idea starts to make a little more sense.
Borrow from 401 (k)
For many workers, this is likely the easiest way to access retirement money early. Some plans allow you to borrow from your 401 (k) for a variety of reasons.
With a 401 (k) loan, you can borrow up to $50.Withdraw 000 (or half of the vested balance in your account if it's less than that). You then repay your account over a period of up to five years (some employers allow a longer repayment period if you buy a home). Also, some plans allow borrowers to refund the account early without prepayment penalties.
It's worth noting that you generally pay back a little more than you took out of the account. This "interest" Actually works to the borrower's advantage. As the funds flow into your account, you essentially recoup some of the interest or capital gains the money would have earned had you not withdrawn it from the fund.
Here's the kicker: Your employer may not offer these loans. Your chances of getting one are better if you work for a large company, many of which now include 401 (k) loans as part of their retirement packages.
Even if your company offers you this option, experts say you should only consider it if you need the money for a real financial emergency. One risk of borrowing from yourself is that you'll have to pay back the loan in less than 60 days if you get laid off or leave your job. Otherwise, the funds are considered an early withdrawal and trigger the 10% penalty.
"Many people believe they are simply paying the money back to themselves with interest. No taxes and no penalties. This is not correct.", Says Michael Mezheritskiy, president of Milestone Asset Management Group in Avon, Conn." When you borrow from your 401 (k), you make repayments with after-tax money. However, once the refunds are deposited back into your account, they will be put on hold again. If you withdraw and take that money out for income purposes, you will be taxed on it again. Therefore, it is double taxation. "
Make special spending from your traditional IRA
Although traditional IRA accounts do not allow loans, they come with certain perks that even a 401(k) does not offer. For example, the government offers penalty-free IRA distributions for those who want to further their education or buy their first home.
The tuition exemption applies to people who use money in retirement to pay for tuition at an IRS-approved college and for books and supplies. If you claim enough credits, you can also use the funds for room and board without penalty. You can even use the distribution to pay educational expenses for your spouse, child or grandchild without worrying about the extra 10% hit. See Pay for a college education with retirement funds .
The tax code also allows you to use $10, 000 of IRA funds to pay for a first home. If your spouse also has an individual retirement account, that means you can take up to 20.000 USD can be received for a down payment and closing costs.
Remember, however, that unlike a 401 (k) loan, it doesn't require you to rebuild your account. That means you'll need extra discipline to replenish your nest egg. If you don't think you can do it, think long and hard before pulling money out of your IRA.
Canceling your IRA
One of the lesser-known ways to access a traditional IRA is to set up "substantially equal periodic payments" (SEPPs). When you set up a SEPP, you make one or more withdrawals per year for either a five-year period or until you reach age 59 ½, whichever is longer.
The tax code actually allows for one of three different calculation methods to determine the amount of your payments, so it doesn't hurt to consult a financial advisor regarding your options.
While SEPPs allow you to avoid the 10% early withdrawal penalty, you are still responsible for paying your ordinary income tax rate on distributions.
The Last Line
You probably shouldn't take money out of a retirement account unless you've exhausted all other options, such as. B. Borrowing from a bank or family member. But if you absolutely must, it's always better to find a way that avoids a big penalty from the government.
"While we prefer to see another strategy for saving for specific goals like education or a down payment or remodeling in a home, sometimes in an emergency, the 401(k) plan loan can be a lifesaver", says Charlotte A. Dougherty, CFP®, founder of Dougherty& Associates in Cincinnati, Ohio.
The 401 (k) loan requirement to repay your account can be a useful tool to ensure you replenish your funds, but it's also a risk if you lose your job. And, of course, if you have both types of retirement funds, investigate where you have the most available money or which vehicle has the lower return on your funds.
For more information, see How much are taxes on an IRA withdrawal??