Using money from your retirement savings may seem like a good option in the face of a hardship. While there may be times when a loan or withdrawal from an IRA or 401(k) plan is your best option, you should be aware of the possible impact to your taxes and long-term savings goals so that you can make an informed decision.
Many 401(k) plans allow you to borrow from your account to buy a home, pay education or medical expenses or prevent eviction or mortgage default. In general, you may be allowed to borrow up to half your vested balance, maxing out at $50,000.
Loans usually must be repaid within 5 years. The deadline may be extended if it's used to purchase your primary home.
Potential drawbacks to 401(k) loans include:
- If you leave your job, even involuntarily, you may have to pay off the loan right away (usually within 30 to 90 days). If you don’t, you'll likely owe income tax on the loan balance. You may also incur a 10% early withdrawal penalty if you're under age 59½.
- Your plan may not allow you to make 401(k) contributions while you have a loan, reducing your potential long-term savings.
- You may pay for taking out the loan with initial setup and maintenance fees.
401(k) and IRA Withdrawals
401(k) plans can allow you to make hardship withdrawals to pay for certain expenses. These include medical or higher-education expenses, funerals, buying or repairing your home, or fees to prevent eviction or foreclosure. With traditional and Roth IRAs, you can withdraw from your account at any time for any reason.
Potential drawbacks to withdrawals include:
- For 401(k) and traditional IRAs, you'll owe income tax. You may also owe the 10% penalty if you're under age 59½.
- Since Roth IRAs are funded with after-tax dollars, you won’t owe any taxes on contributions you withdraw. You’ll still likely face that 10% penalty if you’re under age 59½. You’ll also owe taxes on any earnings you’ve gained if your account has been open for less than 5 years.
Additional Tax Implications
With 401(k) and traditional IRA withdrawals, the money gets added to your taxable income for the year. The added income could bump you into a higher tax bracket. It could also put certain tax credits, deductions and exemptions at risk. 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
If you borrow or withdraw from your retirement savings, you'll lose out on the power of compounding. With compounding, earnings on your savings are reinvested and generate more earnings. You'll lose out on any gains those funds would have earned for you. Over the long term, those earnings could add up to tens or hundreds of thousands of dollars in lost income.
Think long and hard before tapping into your retirement funds for anything other than retirement itself. A personal loan, credit limit extension or other options may make more sense. If that's your only choice, be sure to talk with one of Navy Federal Credit Union’s personal finance counselors about the tax impact.
For professional advice on retirement planning, contact Navy Federal Investment Services.
Navy Federal Financial Group, LLC (NFFG) is a licensed insurance agency. Non-deposit investments, brokerage, and advisory products are only sold through Navy Federal Investment Services, LLC (NFIS), a member of FINRA/SIPC and an SEC registered investment advisory firm. NFIS is a wholly owned subsidiary of NFFG. Insurance products are offered through NFFG and NFIS. These products are not NCUA/NCUSIF or otherwise federally insured, are not guaranteed or obligations of Navy Federal Credit Union (NFCU), are not offered, recommended, sanctioned, or encouraged by the federal government, and may involve investment risk, including possible loss of principal. Deposit products and related services are provided by NFCU. Financial Advisors are employees of NFFG and are employees and registered representatives of NFIS. NFIS and NFFG are affiliated companies under the common control of NFCU. Call 1-877-221-8108 for further information.
This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.