Before the housing crisis, it wasn’t uncommon for people to raid their home-equity piggybanks to pay off bills. Plummeting home values and tougher lending standards helped curb that practice, leading some people to engage in a far more disturbing habit: borrowing or withdrawing money from their retirement accounts to cope with financial hardship.
There may be times when a loan or withdrawal from an IRA or 401(k) plan is your best or only option, but you should be aware of the possible impacts to your taxes and long-term savings objectives before raiding your nest egg:
401(k) loans. Many 401(k) plans let participants borrow from their account to a home, 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:
• If you leave your job, even involuntarily, you must 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 ½.
• You might be tempted to reduce your monthly 401(k) contribution, thereby significantly reducing your potential long-term savings.
401(k) plan and IRA withdrawals. Many 401(k) plans allow hardship withdrawals to pay for certain medical or higher education expenses, funerals, ing or repairing your home or to prevent eviction or foreclosure. You’ll owe income tax on the withdrawal – and often the 10 percent penalty as well.
Unlike employer plans, with traditional IRAs you’re allowed to withdraw from your account at any time for any reason. However, you’ll pay income tax on the withdrawal – and often the 10 percent penalty as well.
With Roth IRAs, you can withdraw contributions at any time, since they’ve already been taxed. However, if you withdraw interest earnings before 59 ½, you’ll likely face that 10 percent penalty.
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.
Bottom line: Think long and hard before tapping 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.
Jason Alderman directs Visa’s financial education programs. To where can i without a participate in a free, online Financial Literacy and Education Summit on April 4, 2011, go to www.practicalmoneyskills.com/summit2011.