The Cost of Tapping Your Retirement Accounts Early

When money’s tight and times are tough, it can be difficult for retirement savers to ignore the money they’ve stashed in a 401(k), IRA or other retirement savings account. Still, while it may make sense in some situations to tap into those accounts early—for example, if a job loss has put you at risk of losing your home—it should always be the very last resort.

Here’s why: Not only will you pay significant taxes and penalties for an early withdrawal, you’ll also reduce the amount of savings in your account that are available to enjoy market gains—and those market gains may make the difference between a successful, leisurely retirement and one that’s a struggle.

First, let’s consider those taxes and penalties. Let’s say you’re not yet 59-1/2—that’s the age at which the early withdrawal penalty no longer applies—and you withdraw $20,000 from your 401(k). Let’s assume you have a 25% effective income tax rate, including state taxes, and add the 10% penalty for early withdrawal (this is assuming you don’t qualify for an exemption, some of which are detailed below). That $20,000 is now just $13,000.

In addition to taxes and penalties, don’t forget the lost investment gains. Consider a 30-year-old worker who, rather than withdrawing $14,000 out of his retirement account instead leaves that money in his 401(k) to grow. Even if he never contributes another penny, that $14,000 would grow to $152,147 by age 62, assuming an 8% average annual return. Of course, that’s not going to happen if the worker withdraws that $14,000 at age 30.*

Still, there are situations in which one can pull money out early from a retirement account without triggering the 10% penalty, though you can’t avoid paying income taxes on the money. Note that the rules for these exceptions vary, depending on whether you have an IRA, 401(k) or other type of retirement plan.

For example, you can avoid the 10% penalty on early withdrawals from both IRAs and 401(k)s if you use the money to pay medical expenses that top 10% of your adjusted gross income.

But while early IRA withdrawals are exempted from the penalty if the money is used to pay health-insurance premiums while you’re unemployed, that particular exemption is not available to 401(k)s. Similarly, while an early IRA withdrawal to pay for qualified higher-education expenses or to pay up to $10,000 for the purchase of your first home won’t be subject to the penalty, an early withdrawal from a 401(k) for the same purposes affords no such relief.

Meanwhile, people who institute a process of withdrawing a series of “substantially equal payments” over time from either account type—under a provision known as the 72(t) rule—can avoid the early withdrawal penalty.

It’s important to note that if your employer offers hardship withdrawals from the company 401(k) plan, and if you qualify for such a withdrawal, you’ll still owe the 10% penalty (assuming you’re under age 59-1/2) plus income taxes on that money.

Another way to pull money early from a 401(k) is by taking a loan, assuming your plan allows them. To avoid the penalty and taxes, you’re required to pay the loan back, with interest. A word of warning: if you happen to lose that job while you have a loan outstanding, you’re required to pay back the balance in short order, or risk getting hit with the penalty and taxes on the amount that you haven’t paid back.

Meanwhile, Roth IRAs offer a somewhat different approach, because the money you’re putting into the account is after-tax rather than pre-tax. Thus, once you own the account for five years there is no limit or penalty on the withdrawal of the contributions you’ve put into the plan (though withdrawing any investment earnings does trigger tax consequences), because you’ve already paid taxes on that money. That makes Roth IRAs to some degree more flexible in terms of pulling money out before you’re ready to retire. In fact, some finance experts suggest using a Roth IRA as a place to stash longer-term emergency savings. That said, others argue that the best use of such accounts is what they were designed for: saving for retirement. As with all things retirement, it makes sense to discuss the ins and outs of various account types with a professional financial planner.

*Hypothetical situation for illustrative purposes only and does not represent actual or future performance of any specific product or investment strategy.

Eric C. Jansen, ChFC is the founder, president and chief investment officer of Westborough Massachusetts-based Finivi, which provides fee-based retirement income planning and investment management services for successful individuals and families nationwide. Do you need help planning for retirement? You can call (800)530-6635 today for a complimentary consultation with a personal financial planner.