Emergencies come up in everyone’s life. No matter how prepared we think we are, they often catch us by surprise. Most people understand that they should have an emergency fund of between three to six months worth of living expenses saved. 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, 401(k), Traditional IRA—when an emergency hits. While this can provide a potentially large pool of money, an early withdrawal from your retirement account should be used only as a last resort.
First, you need some background on the different retirement accounts. Then, you’ll get detailed information on borrowing from your Roth.
Retirement Accounts vs. Borrowing Money
You may have access to several of the many different types of retirement accounts that Americans now use. In addition to a Traditional or Roth IRA (you could have both), many people have access to 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 in order to pay 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.
With an IRA, you can’t take a loan. What you receive is an actual withdrawal. You have only 60 days to pay back the money to your original IRA or put it into a new one before it becomes a permanent withdrawal, with tax and potential penalty consequences. However, 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.
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 funds were not set up to be an emergency fund, and you should not use them in that way, if at all possible.