Senior Finance Advisor

Mar 25, 2021

3 min read

Why Pulling From Retirement Accounts Early Will Cost You In The Long Run

When money is tight, it can be tempting to want to pull out money from retirement accounts. When retirement seems far away and you need the money now, withdrawing from your accounts early may seem like the right decision. But, there are penalties that you need to know about early retirement withdrawal and how it will cost you in the long run.

What is an early withdrawal?

Early withdrawals from your retirement accounts like your 401(k) or IRA is just what it sounds like-it’s taking distributions from your accounts before the age of 59 ½ . If you withdraw before this age, you will most likely be subjected to the 10% penalty tax on this distribution. There are exceptions to this rule, per the IRS. This excepted circumstances include:

  • Made to a beneficiary on or after the death of the participant.
  • Made because the participant has a qualifying disability.
  • Timely made to reduce excess contributions.
  • Made on account of certain disasters for which IRS relief has been granted.
  • Other hardship withdrawals

For a full list of exceptions, see the IRS website. Hardship withdrawals are defined as an immediate and heavy financial need and the account funds are necessary to fund that financial need.

What are the penalties for withdrawing early from my retirement accounts?

Penalties vary depending on your type of retirement account. Read on to see how your various accounts may penalize you.

From your 401(k)

Generally, you can borrow up to 50% (max $50,000) of your balance from your 401(k) and repay it within five years to avoid a penalty. You’ll lose out on the compound interest that is so beneficial to retirement planning, but you won’t pay excess fees.

From your traditional IRA

LIke a 401(k), if you do an early withdrawal on your traditional IRA, you’ll pay a 10% penalty on the amount that was withdrawn. However, unlike a 401(K) retirement account, you won’t have to pay income taxes on the amount withdrawn.

From your Roth IRA

Roth IRAs allow you to make tax- and penalty-free withdrawals before the standard age of 59 ½ for certain items that the IRS has allowed. These circumstances include a first-time home purchase, birth expenses, and college costs. Saving for these excepted circumstances, the same taxes and penalties will begin if you withdraw early.

What is a 401(K) loan?

One option for those who are hurting for cash, especially throughout the economic disaster of 2020, is a loan through your 401(k) retirement account. A 401(k) loan allows you to borrow money from your account for any reason. And, because it’s a loan, you would repay it as you would with any other traditional loan. While you won’t pay taxes or penalty fees when you go the 401(k) loan route, you will incur interest fees. Those interest fees won’t hurt you those, as they are deposited right into your account as you are repaying the loan.

Another benefit of using a 401(k) loan instead of an early withdrawal is that you don’t have to worry about credit checks affecting your credit score or getting denied. Similarly with 401(k) early withdrawal, you can borrow up to 50% of your vested balance OR $50,000. Generally, you are given five years to pay back a 401(k) loan.

Note that you are not able to take out a loan from a traditional or Roth IRA.

It’s not only the penalties and taxes that will cost you in the long run

The bottom line is that when it comes to retirement savings, time is the most critical aspect. Withdrawing money from your retirement account funds-taking out fees and taxes-will cost you in the long run due to missing out on compound interest. Compound interest builds upon your money and lets it begin to exponentially grow the more that you have in your accounts. You will be at a distinct disadvantage come retirement if you decide to do early withdrawals or a 401(k) loan.

Before you decide to take money out of your retirement accounts, it’s best to speak with a financial advisor. They may be able to give you advice that doesn’t involve early withdrawals and will help save you money.

Originally published at https://www.seniorfinanceadvisor.com.