Think it Over
Hard up for cash? It’s easy to let your mind wander to all the money you have sitting in your retirement account, especially if you don’t expect to retire for many years. Couldn’t you just withdraw what you need now and catch up again later?
Not so fast. Making a withdrawal from your retirement account is rarely without strings attached. In some cases, it isn’t even allowed — and if it is, you’ll typically have to pay penalties.
The decision of whether to cash out some of your retirement funds must be made on a case-by-case basis. Here are some common situations in which you might be tempted to make a withdrawal, and what to consider first.
Look at the Big Picture
Before we get into the situations that might require an early withdrawal, it’s important that you understand the consequences involved. As a general rule, “withdrawing funds for your own use is almost never a good idea,” says Mike Webb, vice president of Cammack Retirement Group. You may feel desperate today, but taking funds from your retirement plan can lead to true desperation in the future — when you may be less able to recover financially.
If you withdraw money from your retirement account today, you will be responsible for paying penalties and taxes on the full amount withdrawn, says Mark Fried, president of TFG Wealth Management. And withdrawing extra funds to cover those taxes is a bad idea, Fried says, because you’ll just end up paying more penalties and taxes on that extra amount.
In addition to potential taxes or penalties, early withdrawal from your retirement account also curbs your growth potential. “If funds are left untouched, market growth and compound interest should build up retirement assets significantly over time,” Chris Schaefer, financial advisor at wealth management firm MV Financial, says.
A Financial Hardship
If you’re facing a real financial hardship, you may be able to use some of your retirement funds — but financial planners recommend doing it only as a last resort. Different plans have different definitions of hardships, and in some cases you’ll still have to pay penalties, so you’ll have to check with your individual retirement plan to see if your situation qualifies.
If you have a Roth IRA, you can withdraw your contributions (but not earnings) at any time without paying a penalty.
Some 401(k) plans allow you to borrow from your fund and pay back the loan over five years. A 401(k) loan typically allows a person to borrow up to 50 percent of his or her account balance, up to a maximum of $50,000 — for any reason, according to the IRS. While the loan usually must be repaid within five years, the repayment schedule is sometimes extended if you’re using the money for a down payment on a home. You’ll have to pay interest, but the interest is paid to yourself.
If your 401(k) has a loan provision that allows you to borrow from your account and pay yourself back, using it is “still not a good idea, but much better than taking money out of your IRA,” since early IRA withdrawals involve steep penalties, Fried says. If you have only an IRA, you’re allowed to take a distribution whenever you want, but there may be consequences, such as additional taxes on early distributions, according to the IRS.
If you’ve been slammed with medical expenses, you may be able to withdraw retirement funds without penalty. For instance, when you’re unemployed, you may take penalty-free distributions from an IRA to pay for your medical insurance if you meet eligibility requirements, such as having received unemployment compensation for 12 consecutive weeks, says Ben Barzideh, wealth advisor at Piershale Financial Group.
Penalty-free distributions from IRAs and some 401(k) plans are also available to pay for some medical expenses that are not reimbursed, like payments to acupuncturists, in-home medical care, smoking cessation programs, eyeglasses, or anything that could be deducted on Form 1040, Schedule A on your tax return.
And if you become permanently disabled and unable to work, you can withdraw from your retirement accounts without penalty — there are disability exceptions to early withdrawal penalties from IRAs, Roth IRAs, and 401(k) plans, according to the IRS.
That said, many financial experts recommend preparing for potential disability or medical expenses by purchasing disability insurance or saving money in a health savings account (HSA). That way, you can keep your retirement funds reserved for their original purpose — retirement.
Buying a House
Since a home is often an investment that will appreciate over time, and because owning a home increases quality of life for many people, many experts believe this purchase can be a justifiable reason to withdraw funds from a retirement account. After all, Barzideh says, “you are not using that money to buy a depreciating asset like a car or taking a vacation; you’re using it for something that is an investment.”
If you’ve never bought a home or haven’t owned a home in the past two years, the IRS allows you to withdraw up to $10,000 from a traditional IRA without penalty to buy your house, although you will have to pay taxes on the amount withdrawn, Barzideh says.
If you take the funds from a Roth IRA that has been open for five tax years, then you won’t have to pay penalties and income tax on it, he adds. If you want to use your 401(k) funds to buy a house, then you have to do so as a loan or a hardship withdrawal.
Getting a New Job
Leaving your job with the employer sponsoring your retirement plan is one circumstance that allows for a pre-retirement distribution of your retirement savings. But in most cases, that simply means you’re allowed to withdraw funds from your existing retirement plan and directly roll them over into your new employer’s plan.
“While technically the transaction is a distribution under the law, the funds are transferred directly to the new plan or IRA,” Webb says. “The employee receives no cash and is not taxed on the transaction.”
You may also consider just cashing out your retirement plan when you leave a job instead of rolling those funds directly into a qualified plan with your new employer. While that’s technically an option, you’ll have to pay penalties and taxes on the money if you haven’t reached retirement age. I haven’t found anyone who says that not rolling over the money is a good idea.
One last note: If you retire, quit your job, or get fired at age 55 or later, you can take money out of your 401(k) without paying the usual 10 percent penalty, Barzideh says.