Whether you have a 401(k), an individual retirement account (IRA) or both, early retirement planning sets the stage for a comfortable life down the road. Retirement nest egg’s grow slowly over years, so the sooner you begin stashing cash, the better off you’ll be.
But at some point, you might go back-and-forth with whether to take money from your retirement account early. An early withdrawal can be tempting, especially if you’re sitting on a pile of cash. You might feel that since there’s more than enough in the account, pulling some of your funds won’t make a huge difference—and maybe it wont.
Still, it’s important to understand that the more you dip into your retirement account, the less money you’ll have in retirement.
It’s ultimately your decision, and sometimes, it makes sense to take an early withdrawal. But this isn’t a decision to take lightly. You need to ask yourself some important questions before requesting cash.
1. Why do you need the money?
The purpose of a retirement account is to prepare for the future. This doesn’t mean tapping the account is completely out of the question, but you need to seriously consider why you need funds, and whether tapping your account is the only option.
It doesn’t matter if you have tens of thousands of dollars in your retirement account. This account is not an extension of your personal savings account, nor should it be an account used for any and every emergency. There are, however, instances when tapping the account isn’t the worst thing in the world.
For example, if you hit a rough patch after a job loss, taking cash from a retirement account can provide funds to keep your head above water and ensure you have a roof over your head. This is called a hardship withdrawal. It might even make sense to borrow from a retirement account to pay off large medical expenses or purchase a home. Likewise, funds in your account and go toward paying for home repairs on your primary residence or your child’s college tuition
2. Can you get the money from another source?
But even if there are valid reasons for tapping your retirement account, such as buying a home or paying off a medical expense, consider whether you can get the money elsewhere.Tapping your retirement account should be a last resort and the exception, not the rule. If you brainstorm, you might find ways to get the money you need without draining your nest egg.
For example, rather than withdraw money to buy your first house, ask your realtor about grant programs that provide down payment and closing cost assistance for first-time homebuyers. Or maybe apply for a mortgage through a community bank or credit union, which might offer no money down portfolio loans.
Also, rather than use a retirement account to pay for home repairs, consider tapping your home’s equity instead. And while it’s understandable why some parents choose to pay for their child’s education, you should’t put your child’s educational needs ahead of your retirement needs, especially if your child is eligible for student loans. You may also want to learn more about how a reverse mortgage works and see if that might be an option for you.
3. What are the consequences of an early withdrawal?
Tapping your retirement account isn’t too difficult, and in most cases you only need to fill out a couple of forms to get your cash within a couple of days. But although the process is fairly easy, it’s important that you understand the impact of dipping into your retirement account before the age of 59 1/2.
Whether you take an early withdrawal from a 401(k) or an IRA, you may get hit with a 10% penalty and you may have to pay income taxes on the withdrawal amount. You can avoid a penalty under certain circumstances.
For example, you can borrow up to $10,000 from an IRA to purchase your first home penalty-free; and you can take a penalty-free withdrawal for unreimbursed medical expenses that exceed 10% of your adjusted gross income. If you have to pay income taxes, the amount can be deducted at the time of a withdrawal, or you can request a 1099 at the end of the year.
In the case of a 401(k) loan, be aware that you’re required to pay back this loan through payroll deductions, and you’ll pay interest on the loan. The good thing about a 401(k) loan is that you don’t have to pay the penalty or income taxes as long as you repay funds.
4. How long will you stay with your employer?
Understand that 401(k) rules vary by employer, and some companies do not allow 401(k) loans. If you’re allowed to borrow cash from an employer-sponsored retirement account, you can usually take up to 50% of the vested balance. But before taking 401(k) loan, consider how long you plan to stay with the company.
Generally, you have five years to repay a 401(k) loan. If you leave your job before repaying the loan, the entire loan balance is due within 60 days of your departure. If you can’t repay the remaining balance, the loan is treated as a distribution and you’ll pay income tax and the 10% penalty.
Funds in your retirement account can be a godsend during a financial emergency. Just know that when you borrow against your retirement account, you’re actually borrowing against your future. Weigh the pros and cons of an early withdrawal and only borrow funds as a last resort.
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