Tapping into your nest egg to deal with financial hardship usually isn't the best idea. Here's why.
Borrowing or withdrawing money from your retirement may seem like an attractive option in the face of a financial hardship. Though there may be times when a loan or withdrawal from an IRA or 401(k) plan is your best or only option, you should be aware of the possible impact to your taxes and long-term savings objectives before raiding your nest egg.
Many 401(k) plans let participants borrow from their accounts to buy homes, pay education or medical expenses, or prevent eviction or mortgage default. Generally, you may be allowed to borrow up to half your vested balance up to a maximum of $50,000 or less if you have other outstanding 401(k) loans.
Loans usually must be repaid within five years, although the deadline may be extended if it's used to purchase your primary residence.
Potential drawbacks to 401(k) loans include the following:
- If you leave your job, even involuntarily, you may have to pay off the loan immediately (usually within 30 to 90 days), or you'll owe income tax on the remainder, as well as a 10 percent early distribution penalty if you're under age 59 1/2.
- You might be tempted to reduce your monthly 401(k) contribution, thereby significantly reducing your potential long-term savings.
- You may pay for the privilege of taking out the loan with initial setup and maintenance fees.
401(k) plan and IRA withdrawals
Many 401(k) plans allow hardship withdrawals to pay for certain medical or higher-education expenses, funerals, buying or repairing your home, or fees to prevent eviction or foreclosure. You'll owe income tax on these types of withdrawals as well as the potential 10 percent penalty, and your deferral contributions will be suspended.
Unlike employer plans, with Traditional IRAs, you're allowed to withdraw from this account at any time for any reason. However, you'll pay income tax on the withdrawal and often the 10 percent penalty as well if you're under the age of 59 1/2.
With Roth IRAs, you can withdraw contributions at any time, since they've already been taxed. However, if you withdraw interest earnings before age 59 1/2 and your Roth IRA has not been opened for five years, you'll likely face that 10 percent penalty and owe taxes on the earnings.
Further tax implications
With 401(k) and Traditional IRA withdrawals, the money is added to your taxable income, which could bump you into a higher tax bracket or even jeopardize certain tax credits, deductions, and exemptions tied to your adjusted gross income (AGI). 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
Finally, if you borrow or withdraw your retirement savings, you'll lose out on the power of compounding, where interest earned on your savings is reinvested, and in turn, generates more earnings. You'll lose out on any gains those funds would have earned for you, which over a couple of decades could add up to tens or hundreds of thousands of dollars in lost income.
Think long and hard before tapping into your retirement savings for anything other than retirement itself. If that's your only recourse, be sure to consult a financial professional about the tax implications.
For professional advice on retirement planning, contact Navy Federal Financial Group.