Financial crises come up in everyone’s life. Conventional wisdom says you should maintain an emergency fund of between three to six months’ worth of living expenses. But that’s a tall order for many people, especially in today’s economy.
Now, more and more people are reaching into their retirement accounts—Roth IRA, Traditional IRA or 401(k) plan—when an emergency hits. While doing so can provide a potentially large pool of money, such an early withdrawal (if you’re not retired or over age 59½) should be used only as a last resort.
First, you need some background on the different types of retirement accounts out there. Then, you’ll get detailed information on borrowing from one.
Retirement Accounts vs. Borrowing Money
In addition to a Traditional or Roth IRA (you could have both), many people maintain a 401(k) retirement account through their employer. These retirement funds may offer a large pool of cash to tap during an emergency or for other big-ticket items that have not be adequately saved for, such as college education, buying a home or starting a business. An early withdrawal can help you escape from having to borrow the money needed for these items.
Borrowing from a financial institution can subject you to high interest rates. This is especially true for those with poor credit, who may not have access to traditional lending options or be able to borrow money at a reasonable interest rate. Withdrawing the money from your retirement account is a way to fund these items without borrowing money from a third party that charges you interest. That doesn’t make those loans free. Depending on your age and various tax rules, you may owe both income taxes and penalties on the money you take out of retirement accounts.
Borrow or Withdraw: 401(k) vs. IRA
Accessing your retirement funds comes with different rules, depending on whether it’s a 401(k) or an IRA.
Based on your company’s rules, you can often borrow up to $50,000 (or half your vested balance) from a 401(k) and repay it within five years —unless you leave the company sooner, in which case you have 60 days to repay or face tax consequences and possible penalties.
You can’t officially borrow from an IRA. The money you receive is an actual withdrawal, albeit a temporary one: You have only 60 days to re-deposit it, either into the same IRA or put a new one before it is considered a permanent withdrawal, with tax and potential penalty consequences. However, a Roth IRA (see below) offers special opportunities to escape taxes and penalties that aren’t available when you withdraw funds from a Traditional IRA.
Knowing all this, let’s look at the pros and cons of taking funds from your Roth—beyond staying out of the clutches of a bank or other lender.
Pros of Early Withdrawal from Your Roth
A Roth IRA offers investors a unique tool for accessing money in a pinch. You may withdraw your contributions from a Roth IRA at any time and any age without owing any income taxes on the money you take out. The reason: You have already paid taxes on the money you deposited. Roth IRAs take after-tax contributions (you didn’t get a tax deduction on the money).
A word about “contributions”: This is the term for the money you deposited into your Roth account. Your total Roth IRA balance will include both your contributions and your earnings—that’s the interest or dividends your contributions have earned on your investments since they were deposited.
The issue is, when can you withdraw earnings without paying the 10% early withdrawal penalty mandated by the IRS? Read below for the details. All the same, the benefit of being able to withdraw your contributions without penalties or tax repercussions is a great benefit provided only to Roth IRA investors.
Drawbacks of Early Withdrawal from Your Retirement Accounts
The cons of withdrawing money are common to all retirement accounts, but with different wrinkles depending on the laws and regulations that govern them.
Early Withdrawal Penalties (advantage: Roth)
In many cases, you may have to pay some level of early withdrawal penalty if you remove money from any type of retirement account. For example, if you withdraw money from your 401(k) retirement plan or from a Traditional IRA before you are age 59½, you will not only have to pay tax on all the money you withdraw at your normal tax rate, but you will also owe a 10% early withdrawal penalty.
The combination can wipe out 40% or more of your withdrawal before you could spend a single penny. For example, if you withdrew $50,000 early from a Traditional IRA or 401(k) retirement plan, you could expect to lose $5,000 because of the 10% early withdrawal penalty and another $14,000 in taxes owed (assuming that you are in the 28% tax bracket).
With a Roth IRA, you will only be hit with the 10% early withdrawal penalty—and owe taxes on—your earnings (not your contributions). So if you had $20,000 in contributions and took out $25,000, you would owe on the $5,000, not the whole amount.
You can escape both the tax and the penalty if the account is at least five years old and if you are 59½ or meet a few other specifications (being disabled is one).
Lost Future Earnings (no advantage at all)
The beauty of a Roth IRA and other retirement accounts is the power of compounding interest. If you withdraw money from your Roth IRA or retirement accounts early, that money will never compound because it won’t be there. Subsequently, the interest you would have earned if you had left your money and initial earnings in the account to grow further will never earn interest either. Here’s a quick example: let’s assume you invested $5,000 every year for 20 years, earning an 8% annual rate of return. After those 20 years, your nest egg would have grown to $228,000. If you never invested another dime into your nest egg and just let it compound for another 20 years, you would be sitting on $1.06 million.
But, what would happen if you had taken just one $20,000 early withdrawal from your Roth IRA after that first 20 years? In the end, your nest egg would only have grown to $973,000. While $973,000 for retirement is nothing to sneeze at, taking that $20,000 early cost you approximately $93,000 in future earnings from compounding interest.
Never Cash Out Retirement Accounts
If withdrawing some money from a 401(k) for an emergency is a questionable idea, cashing it out entirely is a terrible one. It may seem logical if you’re switching jobs; after all, you don’t want to leave the money behind, right? and that lump sum looks mighty tempting. But liquidating the account not only a dumb move, but a financially painful one.
How dumb is cashing out your retirement early? Read on.
Four Reasons Why Cashing Out is a Bad Idea
1. It’s Unnecessary
It may surprise you to know that you actually don’t have to make any moves with your 401(k) when you change employers: You can keep it with the old firm’s plan managers, and let it keep on growing at that lovely tax-deferred rate. There are drawbacks to this–you won’t be able to contribute to it off the top of your paycheck anymore, and there may be extra administrative fees. But if it’s an extremely good plan, and better than the one at your new workplace (or there isn’t one at your new workplace), leaving the money behind may be the best move.
2. Those fees and taxes
Remember that early withdrawal penalty we mentioned above? It applies here too. If you ask your retirement-fund provider to liquidate your account and send you the proceeds, you will have to pay that fee to the Internal Revenue Service (assuming you’re under 59½). You won’t have a choice: the administrator will deduct it automatically from your check. And if you thought paying 10% on a mere withdrawal hurt, imagine the crack it’ll make in your entire nest egg.
But wait, there’s more. Because your 401(k) was funded with pre-income tax dollars, you’ll get hit with a tax bill in the year you take possession of those funds. It doesn’t matter if it is an early withdrawal or not. Depending on your situation (and tax bracket) that can take an additional 15% to 35%. If you combine income taxes and the early withdrawal penalty, you could lose as much as $4,500 of a closed $10,000 withdrawal.
3. Rolling over is easy
Rolling over your retirement from your previous employer to either your new employer’s retirement plan or to an IRA (either Roth or Traditional) is a simple process. Your new HR department should have a form that will allow your new plan provider the ability to pull the funds out for you and reinvest them. You will avoid both income taxes and withdrawal penalties by doing this. And you’d keep your money working for you.
4. Lost growth on those funds
If you left $10,000 in a diversified, low-cost portfolio that earned 7% annually (on average), it would grow to nearly $40,400 over 20 years. If you simply withdraw the funds and spend them elsewhere you’ll be missing out on all that growth. Even if you reinvested what was left after income tax (let’s say you lost 25% of your entire distribution), you would start with $7,500. With the same 7% growth over 20 years it would grow to just $30,290. The $2,500 hit has cost you over $10,000.
When you are backed into a corner and have no other option, it may give you a sense of comfort to fall back on an early withdrawal from your retirement accounts. But it should be your funding of last resort.
Dipping into your retirement accounts can devastate your future earnings. Your retirement account should never be seen as an ATM where you can quickly access funds when you need to, or even as an emergency fund – unless you are in the most dire of situations and have used all other options first. And certainly don’t cash out of a workplace retirement plan just because you’ve left that workplace behind; there are too many better ways to handle that lump sum.