Should You Withdraw Retirement Funds Early for Extra Cash?

Using money from your retirement savings may seem like a good option in the face of a financial hardship. There may be times when a loan or withdrawal from an Individual Retirement Account (IRA) or 401(k) plan is your best option. But before you take out funds, make sure you’re aware of the possible impact an early distribution may have on your taxes and long-term savings goals.

401(k) loans

Many 401(k) plans offer exceptions that allow you to borrow from your account (penalty-free) to buy a home (for eligible individuals), fund education, pay medical expenses or prevent eviction or mortgage default. In general, you may be allowed to borrow up to half your vested balance, maxing out at $50,000.

Loans usually must be repaid within 5 years. The deadline may be extended if the money is used to purchase your primary home. According to the Internal Revenue Service (IRS), your repayments may be eligible to be suspended if you’re performing military service. But if you leave your job, you’ll be required to repay the full amount you borrowed much sooner.

Here are a few potential drawbacks to 401(k) loans:

• If you leave your job, even involuntarily, you may have to pay off the loan right away (usually within 30 to 90 days). If you don’t, you’ll likely owe income tax on the loan balance. You may also incur a 10% early withdrawal penalty if you’re under the age of 59½.
• Your retirement plan may not allow you to make 401(k) contributions while you have a loan, reducing your potential long-term savings.
• You may pay for taking out the loan with initial setup and maintenance fees.

401(k) and IRA early withdrawals

401(k) plans can allow you to make hardship withdrawals to pay for certain expenses. These include medical or higher-education expenses, funerals, buying your home (for eligible individuals) or fees to prevent eviction or foreclosure. 

With traditional IRAs and Roth IRAs, you can withdraw from your account at any time for any reason. But there are many factors to consider before you do so. 

Here are some potential drawbacks to 401(k) and IRA withdrawals:

• For 401(k) and traditional IRAs, you’ll owe income tax. You may also owe the 10% penalty if you’re under the age of 59½.
• Roth IRAs are funded with after-tax dollars, so you won’t owe any taxes on contributions you withdraw. You’ll still likely face that 10% penalty if you’re under the age of 59½. You’ll also owe taxes on any earnings you’ve gained if your account has been open for less than 5 years.

Additional tax implications for taking out a retirement loan

The money from any 401(k) and traditional IRA withdrawals will be added to your taxable income for the year. That added income could bump you up into a higher tax bracket. It also could put certain tax credits, deductions and exemptions at risk. You may end up paying half or more of your withdrawal in taxes, penalties and lost or reduced tax benefits.

Missing out on compound earnings

If you borrow or withdraw from your retirement savings, you’ll lose out on the power of compounding interest. With compounding, earnings on your savings are reinvested and can generate even more earnings. You’ll also lose out on any gains those funds would have earned for you if you hadn’t taken out a loan. Over the long term, those earnings could add up to much of your lost income.

Navy Federal Credit Union is here to help with your financial needs

Think long and hard before tapping into your retirement funds for anything other than retirement itself. A personal loan, home equity loan, credit limit extension or other option may make more sense. If a retirement loan seems to be your only choice, connect with one of Navy Federal’s personal finance counselors to talk about the potential tax impact.

For professional advice on retirement planning, contact Navy Federal Investment Services.