Saving for Retirement
Best Ways to Raid Your Retirement Accounts
When you have to tap your nest egg early, the key is to minimize the tax bite.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
July 13, 2009
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The problem: Your savings are all tied up in retirement accounts but you really need the money -- now. You know you shouldn't crack your nest egg until it's time to retire, but these are extraordinary times. Maybe your rainy-day fund has dried up, your credit-card rate has soared, or your home-equity line of credit has been yanked.
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There are ways to tap your IRA or 401(k) without triggering the usual 10% early-withdrawal penalty. But unless you have a Roth IRA, you'll still have to pay income taxes at your regular rate on the money you take out. Some options depend on your age and whether you are employed.
Borrow from your 401(k)
If you are still working, you may be able to borrow up to half of the balance of your 401(k) or similar employer-based retirement savings account, up to a maximum of $50,000. (The majority of 401(k) plans allow loans, but specific rules are determined by the plan sponsor.)
On the plus side, interest rates on 401(k) loans tend be lower than you will find elsewhere. Because you are borrowing from yourself, your credit score doesn't matter and your loan repayments plus interest go back into your account.
Normally, you have up to five years to repay your loan (longer if the money is used as a down payment on a first home). But if you fail to pay it back on time, the unpaid balance will be treated as an early distribution and will be subject to taxes and the 10% early-withdrawal penalty if you're younger than 59½. If you lose or leave your job, your loan payoff is usually due within 90 days -- at a time when you may be least able to repay it. So don't consider borrowing from your retirement plan unless your job is secure.
New research from the Federal Reserve suggests that borrowing from a 401(k) may make sense if the interest rate you would pay for an alternative loan, such as a car loan or credit-card , is higher than the rate of return you expect to earn on investments inside your 401(k) account. A 401(k) loan-handled properly could be the least costly source of funds, according to economists Geng Li and Paul Smith. They predict that the recent tightening of terms in mortgage and consumer lending will boost 401(k) borrowing.
But handled improperly, borrowing from your 401(k) can inflict major damage to your long-term savings. The key is whether you continue to contribute to your 401(k) plan while you repay the loan.
Say you have $40,000 in your 401(k) plan earning an average annual return of 7%. (Yes, such returns, or even higher, are possible now that the stock market has started to recover from the lows it reached in March.) Also assume that you contribute $200 a week to your 401(k). If you borrow $20,000 from your plan at 5% interest and repay it over five years -- but you stop contributing to your plan in the interim -- that loan will cost you more than $365,000 in lost savings by the time you retire in 30 years. However, if you continue to contribute your usual $200 a week while you make the loan payments, the long-term impact on your saving would be less than $8,000.
Borrowing from your 401(k) is a much better alternative than requesting a hardship withdrawal, which is generally reserved for dire financial situations, such as preventing foreclosure. Hardship withdrawals are treated as early distributions and are subject to taxes and penalties. So, for example, if you're in the 25% federal income tax bracket and your state tax rate is 5% and you are younger than 59½, you could lose 40% of your 401(k) distribution to taxes and penalties. Once you take a hardship withdrawal, you can’t put it back so it permanently reduces the size of your nest egg. And, the law prohibits you from making new contributions for at least six months following a hardship withdrawal.
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Reader Comments (6)
Posted by: linja at 07/16/2009 03:37:16 PM
I have a question about avoiding the 10% penalty for early 401(k) withdrawal. I retired at 53 (almost 54). I have the option of leaving my money in the company sponsored plan. It is diversified and I'm happy with the funds I have. If I wait until I am 55 to withdraw funds, am I still liable for the 10% penalty?
Posted by: Mary Beth Franklin at 07/20/2009 12:15:16 PM
Hi linja. This is Mary Beth, author of this article. If you are satisfied with the investment choices in your former employer's 401(k), leave them there. However, you won't qualify for the penalty-free withdrawal when you turn 55. It only applies to workers who leave their job when they are 55 or older. Hope this helps.
Posted by: Yogi at 07/21/2009 05:26:13 PM
Is there a way to avoid penalty if a foreign worker has to do early withdraw because he returning to his home country?
Posted by: yada at 07/25/2009 06:22:48 PM
I added husband as beneficiary on my IRA I had before marriage. I want to change beneficiaries and remove him, don't I have the right to change beneficiaries on my own acct?
Posted by: Mark from L.A. at 08/04/2009 06:33:16 PM
Many people retire before age 59 1/2 and avoid the penalties of early withdrawl by "annuitizing" their 401(K) plans. This could be an option of linja. The Plan Provider could help with the details of annuitization.
Posted by: Mack at 09/03/2009 10:23:05 AM
If you lose your job,can you take some of your 401k rollover money and pay off your debt so you can survive on your new income that is 50% less then what you were making and avoid the penalty?