Early Withdrawal Penalties – The Real Cost of Withdrawing Retirement Funds Early

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!

When You Can Make Early Withdrawals from Retirement Accounts

According to the Pension Protection Act of 2006, you are allowed to make withdrawals from your 401(k) in certain circumstances. There are a few situations that the IRS will consider acceptable reasons to withdraw from your retirement account.

1. One of the most common reasons is for un-reimbursed medical costs for you or someone that depends on you. If you have fallen ill, or something tragic happened to your spouse or a kid, you can be left with a massive amount of hospital bills. If you don’t have the money to cover those expenses, then you can make a withdrawal from your 401(k).
2. Another circumstance you can withdraw from your account is if you’re responsible for paying for college tuition or a related education cost for yourself, your spouse, or one of your kids. The average cost of a college degree is anywhere from $10,000 to $25,000 a year. For a lot of families, that college education can be a difficult bill to cover. If you find yourself facing expenses college bills, then you can legally dip into your 401(k) to get the money that you need.
3. Some of the other hardship withdrawal are funeral costs or some expenses for repairs for your home. There are plenty of expenses that you can’t plan for, like a death in your family or a tree falling on your home. You never know what’s going to happen tomorrow. If you find yourself responsible for a massive amount of debt and bills, then withdrawing money out of your 401(k) might be the only possible route that you have.

Before you do that, regardless of which of these scenarios you fall under, it’s important you understand all of the fees and penalties you’re going to face.

These Are The Real Costs of Withdrawing Retirement Funds Early!

Every year, I hear a lot of stories about people who make the withdraws from their 401(k), and it turned out to be the worst mistake of their life. Here is why it costs so much to make early retirement account withdrawals:

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 up front 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.

Leaving your money in your retirement accounts means you will need to save and invest less money over your remaining working years. It’s better to get ahead now instead of trying to play catchup with your retirement savings when you are older.

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.

Exceptions

Withdrawing from your retirement account can seriously cost you. There are a few exceptions that you can meet that will let you bypass the taxes and fees. One of those is if you leave your employer after you turn 55, then you can be exempt for the penalties. This is not every case though.

Some of the other exemptions are permanent disability or if you have a ton of medical bills. If you have healthcare bills that are more than 7.5% of your adjusted gross income, then you might be able to withdraw from your retirement account without having to pay the penalties.

Taking on a Loan on your 401(k)

What some people don’t know is that they can take out a loan on their 401k. Depending on who much is in your 401k, you can secure a loan based on that money. These loans are not subjected to any of the taxes or penalties. You can make contributions to the plan while you’re paying back the loan. In most cases, you’ll be able to take out a loan that is around 50% of the total value of your account.

One of the main disadvantages of taking out a loan on your 401(k) is that if you were to leave before you paid back the loan, you would be responsible for paying back all of the remaining balance. Failure to repay the outstanding loan will result in immediate taxes and early withdrawal penalties, which can further compound an already bad situation.

Also, when you take out a 401(k) loan, you will be receiving dollars that have not yet gone through income taxes and then paying that loan back with dollars that have been taxed. When you withdraw the money at retirement, those withdrawals will be taxed again. So any money you pay back into the account from the loan will be subject to double taxation.

On the flip side, there are some benefits to these plans. If you’re ever in need of money, then taking out a loan is going to be a much better idea versus withdrawing your money. These loans will give you access to money quickly, at a low-interest rate, and they won’t appear on your credit score.

Should I Use My Retirement Accounts to Pay Off Debt?

You will likely be better off leaving your money in your retirement account unless you are in a very bad financial situation with crushing debt and no way to repay it. 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 Craigslist, eBay, or websites like Decluttr.

If you’re looking to make some extra money, there are dozens and dozens of different things that you can do to make money. In fact, there are plenty of ways that you can even make money while sitting on your couch. Things, like selling on Etsy or doing survey panel websites, will let you make some extra cash while you binge watch your favorite shows on Netflix.

Stay the Course

Everyone’s situation is different, which means that I can’t say that you should NEVER withdraw your retirement account early, but I would strongly advise against in 99% of cases. You should do whatever you can to avoid having to do that.

Your retirement is one of the most important things that you can plan for. You are working hard to live the retirement of your dream, but there are hundreds and hundreds of things that can go wrong and cause your plans to go off the tracks. It can be overwhelming and confusing trying to plan for your retirement and ensure that you’re taking all of the necessary steps.

If you have any questions about your 401k or other retirement components, please continue to look at the other articles on my site, or feel free to contact me with your concerns.