The economy is tough right now. Gas and food prices are going through the roof, energy and housing prices are rising, and many people are struggling to make ends meet.
When times are tough, making early withdrawals from your retirement funds can seem like a quick source of cash. It is. But it can be an extremely expensive source of quick cash. Many people don’t realize that making early retirement withdrawals can hit you four times at once!
Taxes
The first thing that is going to get you is the taxes. Qualified retirement plans such as IRAs and 401(k) plans (and others) have some nice tax advantages. When you make an investment into a Traditional retirement plan such as a Traditional IRA or Traditional 401(k), the money is not taxed until you withdraw it. This is designed to allow you to invest more money upfront and give you years of tax free growth. When you withdraw that money early, you lose that tax advantage and must pay the taxes immediately.
Early Withdrawal Penalties
Early distributions from an IRA, 401(k), 403(b) or other qualified retirement plan are subject to a 10% early withdrawal penalty. That means not only are your withdrawals taxed, but an additional 10% is taken from the withdrawal to pay the penalty. Double-whammy!
Less Money for Future Growth
Compound interest is the most important thing you have working for your retirement. The more time that compound interest works in your favor, the more money you will have when you retire. Here is a nice illustrated example of how much compound interest can work in your favor.
Possible Market Losses
If your retirement account holdings have depreciated, not only will you have to pay taxes and early distribution penalties, but you may be paying them on less money than what you originally invested. Overall, the markets have not done very well the last year or so, and it is possible that some of your investments have lost money. Leaving the money in your investments gives them time to appreciate and not only regain their previous value, but hopefully appreciate beyond your original investment.
Stay the course. If at all possible, try to avoid withdrawing your retirement funds for short term needs. There may be other ways to get the funds you need, such as working overtime, taking a part time job, or raising funds by having a yard sale or selling unneeded items on eBay.
{ 13 comments… read them below or add one }
I know so many people who have been slammed by making this mistake. It’s the number one reason I think everyone has to have a backup plan for job loss. It’s inevitably the route people choose who have poor money management skills and don’t have a savings account to cover expenses for income loss.Of course, once you pull the trigger and do the withdrawal, it’s a huge cycle because you can’t afford the tax penalty and on and on and then oooooh the debt I’ve seen people have to dig out of because of it.
When I studyied commercial law in college some time ago, I remembered vividly that retirement account balances of up to 1,000,000 cannot be taken away from you in the case of bankruptcy. So if you really are in cash crunch, do what PAtrick told you to do.. Or apply for a loan at Prosper if you don’t want to get into credit card debt..
One option if you absolutely have to have money is instead of withdrawing from your 401k, borrow from it. This assumes of course its for one of the IRS defined emergencies….not things like you mentioned (food, bills etc). In these kind of cases I think “extreme frugal” is the right course of action. When I got laid off Ramen soup with almost anything you can think of mixed in -10 for a dollar!
And depending on what you withdraw, it can bump you into a higher tax bracket, right?
Yes withdrawals from a retirement account should be an absolute last resort. Like many financial mistakes the time to avoid this mistake is not the day you make the decision but your actions for years in advance. So you have a ready source of emergency funds, and other savings… to draw on in tough times…
I’m just glad that I can’t withdraw anything on my retirement. As a participant in an ESOP, it isn’t even available to me. Woo Hoo!
Borrowing is bad, too – you get taxed twice. Once when you borrow the money (it’s taxed as income), and then you pay it back with income you’ve been taxed on.
Oops, I got that wrong – you don’t get taxed when you borrow the money. But it’s still a bad idea
Sarah,
I think you had it right. You do get taxed on the money twice when you take a loan from the retirement account.
When you take a loan from a tax advantaged retirement account, you repay the loan with after tax money. When you make normal withdrawals or are forced to take a required minimum distribution, the amount withdrawn is again taxed at your ordinary income tax rate.
So yes, the amount of the loan you took from the retirement account is eventually taxed twice.
What will be the net after taxes and penalties (federal, state and penalties) in the case of early withdrawal.
Thanks.
Asher, it’s tough to say without knowing your full tax situation. Basically, it will be a 10% penalty, then state and federal taxes at your tax rate. For more information you should contact a tax professional or the IRS.
My company stopped working with a service that took care of our 401K.
I called to see what I needed to do, they said I could just leave it there and
not have to do anything. The next month I got a check from them and the taxes were taken out. I called and told them I had not asked for this and way I got this. They told me that I would have to take this up with the IRS and that they had given me the wrong information and they were sorry. But that they either could not or would not do anything else.
I put all of the money into a IRA but I still had $4,000 taken out and sent to the IRS. I don’t have enough money to make up the $4,000 that was sent to the IRS will I be penatlized on that $4K since I did not have the money to re-do the IRA? I don’t have the money the government does?
HELP!!
David, I recommend speaking with a tax professional, ASAP. You won’t have to pay early withdrawal penalties if the money is rolled into an IRA quickly enough. However, I’m not sure of the exact details of your case, so it’s best to speak with a professional. Best of luck!