Using Retirement Funds in a Financial Emergency is Rarely Worth It

August 23rd, 2010 Brock Hailes Leave a comment Go to comments

When you’re strapped for cash, the last place you should ever turn to for assistance is your retirement account. That’s the point of having one–so you don’t spend the money until you retire. That said, when you’re facing a serious financial emergency like a job loss or medical expenses, it may seem necessary to tap into the cash you’ve saved.

Sometimes the current situation is dire enough to warrant using money now that was planned for the future. If you find yourself in this position, think very carefully about the consequences of using retirement funds in a financial emergency before making a withdrawal. It probably won’t be worth it, though there are certain circumstances in which you can do it with minimal financial impact.

The Cost of Early Withdrawals

Withdrawing from a qualified retirement plan before retirement age (59 1/2) will result in a hefty tax penalty. Accounts subject to a 10 percent early distribution tax include a 401(k), 403(b) and IRA.

The 10 percent is applicable to the “taxable amount” of your funds, the distribution amount, but you will end up paying even more than that. The taxable amount is also considered income, and will be taxed as such in addition to the 10 percent penalty.

Here’s the really bad one: If you opened a SIMPLE IRA in the past two years and want to make an early IRA withdrawal, the funds will be subject to a 25 percent tax penalty.

Exceptions that Waive Early Withdrawal Penalties

There are a couple of circumstances in which you are allowed to take money out of your retirement account without suffering the early distribution penalty. The specific rules that apply to each type of retirement account can be quite complicated, but generally, qualifying for one of these two options is the only way to withdraw funds penalty-free.

Loan

Every employer-sponsored retirement plan is different, but some allow the account holder to take out a loan on the balance. Forbes.com reports the current law allows you to borrow up to $50,000 or 50 percent of your vested balance, whichever is less. You also have a five year limit on paying it back.

Of course, this is not the same as taking some money out of your savings account and putting it back later.

A loan from a retirement account requires a strict repayment plan that begins soon after your withdrawal and the payments will be automatically deducted from your paycheck. Also, since it is a loan, it will be subject to fees and interest. There is usually a loan origination fee, which can run around $75, no matter how big or small the loan. The plus side is, however, that the interest rate is low and you actually pay yourself, growing the account a little more.

There are a couple of downsides to borrowing from your 401(k) or similar retirement account, though. First, any of the money you take out is losing the interest it would have gained. Second, the money you use to repay the loan is not tax sheltered, which means you’re depositing post-tax income and defeating the greatest benefit of a retirement plan such as a 401(k).

Hardship Distribution

It is possible in some cases, if the plan allows for it, to take an early distribution from your retirement account due to financial hardship. However, it isn’t easy to prove you qualify for a hardship distribution, but if you can, this is the other way in which you can make a 401(k) withdrawal or similar plan distribution early without being taxed an additional 10 percent.

A hardship, according to the IRS, must be both immediate and heavy. The amount must be sufficient to cover the cost of the hardship, and the account holder must not have any other resource available to tap into, including a spouse or child’s assets. Also, plans often limit what the hardship distribution can be used for. For example, you may be able to acquire a hardship distribution to cover medical or funeral expenses, but not a home purchase or tuition payment.

Again, there are disadvantages to taking this route. A hardship distribution usually results in the account holder being prohibited from both making elective contributions to the account and receiving employer contributions for at least six months. The withdrawal is also still considered income, and you’ll have to pay taxes on it. Additionally, there is no repayment plan, so your retirement savings will be reduced by whatever you withdraw.

As you can see, using retirement savings to cover an emergency expense is possible, but not really worth it or recommended. There is no way to access your retirement funds early completely without some sort of negative consequence, so you should seriously weigh all of your options before choosing to do so.

Have you been tempted to withdraw from your retirement in the past? Did you find an alternative solution or do you regret the decision?

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