Think Twice Before Withdrawing Retirement Funds While Still Employed

An old couple smile while going thru the cell phone Your workplace retirement plan probably represents one of your most significant financial assets. But should you ever consider using some of those funds to address an immediate financial need? If you’re participating in a qualified plan such as a 401(k) or 403(b), you may be eligible to access the funds you’ve accumulated in your plan through a retirement plan loan, an in-service distribution, or a hardship withdrawal. However, taking withdrawals from these accounts to meet a short-term need ultimately compromises your ability to maximize your long-term savings. So you should look very carefully at how you might be losing out before you leap.

Your first step: Tap into an emergency fund

Achieving your long-term retirement goals means allowing the years to work in your favor. So it makes sense to leave those savings intact and allow them to benefit from tax-deferred earnings and the compounding of those earnings.

The best way to avoid having to compromise your future financial security to address today’s needs is to have an emergency fund as your primary resource. Building this type of fund can help you avoid dipping into retirement savings or other monies set aside for long-term goals. Generally, you should have enough emergency fund cash to cover three to six months of living expenses in the event of an emergency, such as medical bills or being laid off from your job. If you currently have little set aside, aim to build a rainy day fund of at least $500. Once you've reached that threshold, try to get to $1,000, then $1,500, and so on, and plan to replenish the fund whenever you withdraw from it.

Other alternatives
If you’ve neglected to build an emergency fund, or need more than you’ve managed to save, you may want to explore opportunities to access money from your retirement plan. Let’s take a look at some of the alternatives that may be available to you while you're still employed.

Retirement Plan Loans
Once you have met your plan’s vesting requirements, you may be able to borrow from your account balance (if your plan permits). Depending on the rules of your plan, you could borrow up to the lesser of $50,000 or 50% of your vested balance. Generally, a plan loan must be repaid within five years from the date you borrowed the funds, although the repayment period can be longer if you use the funds to purchase your primary residence.

Borrowing from your own retirement account does have some advantages compared to loans from other sources. Applying can be relatively quick and easy, with no credit check required, and generally you will find few restrictions on your reasons for borrowing. The amount you borrow is not subject to income tax or premature withdrawal penalties – as long as you pay back the loan as required by your plan. When repaying the loan, the interest rate will typically be lower than what you'd pay to borrow elsewhere. And, in some plans, the loan payments go directly back into your plan account.

However, there are a number of potential drawbacks. Like any other loan, there may be some loan origination fees. Typically your interest payments won’t be tax deductible and the rate may vary based on market benchmarks or plan rules. Your loan payments, including interest, go back into your account as after-tax dollars. However, once you later take retirement distributions, the entire amount you withdraw will be taxed again.

In addition, even though you’re borrowing from your own account, you can’t just walk away from repaying the loan. If you leave your employer and have an outstanding loan balance, you might have to pay off the loan within 60 days, or declare the entire amount of the loan as a taxable distribution, depending on plan rules. If you default on the loan, the unpaid balance may be subject to tax. There could be a 10% federal premature distributions tax as well as a state penalty.

Of equal importance, before taking a loan, you need to consider any potential "opportunity cost." Under some (but not all) plans, borrowed assets returned to the plan will be segregated and no longer qualify for compounded earnings. This can have a significant impact on your nest egg and future retirement income.

In-service distributions
Some plans allow you to request an "in-service distribution" of employer contributions once you've reached a certain age, participated in the plan for a specified period of time, or after the contributions have been in your account for a required amount of time. In addition, you may be allowed to take in-service distributions of your own pre-tax contributions once you reach age 59½. One advantage of these in-service distributions is that they can be arranged for any reason, without your having to qualify as having a specific “hardship.” The downside is that you’re reducing your retirement savings and sacrificing your opportunity to continue building your savings on a tax-deferred basis. Of course, you’ll also have to pay income taxes, which further reduces the amount of your withdrawals.

Hardship withdrawals

The IRS allows withdrawals from qualified plans in certain hardship situations – for example, to pay tuition or medical expenses, purchase or repair damage to a principal residence, or avoid foreclosure on a home. Employers are not required to allow hardship withdrawals or to grant them for all the IRS-approved reasons, so you would need to find out if your plan does allow them

This type of withdrawal requires that you demonstrate enough of a hardship to justify needing it, and that you show that you have no other resources available to address the need. The rules on how a hardship must be proven can vary from plan to plan. Generally, since the requirements are more restrictive, applying for a hardship withdrawal should be considered only after you’ve explored other possibilities. In order to even qualify, you may be required to first exhaust all distributions available through nontaxable loans from other plans maintained by your employer.

Hardship withdrawals also come at a high cost. Once you receive the withdrawal, you’ll owe income tax on any pretax money you withdraw, including salary deferrals, employer contributions and investment earnings. If you're under age 59½, you may also incur a 10% federal penalty for a premature distribution as well as a possible state penalty.

In addition, you will be significantly diminishing the power of your long-term savings. You’ll forgo the compounding of tax-deferred earnings on the amount you withdraw, which means less money saved for your retirement years. And depending on how your plan works, after taking a withdrawal, you may be required to suspend contributions to your plan account for a specified period of time, thereby losing out even more.


 

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