At the end of your career, your retirement account should typically be the treasure waiting for you at the end of the rainbow. Is it a good idea to dip into your retirement account early?
Should You Dip Into Your Retirement Account?
We do not recommend for you to dip into your retirement funds by either taking out a loan or by cashing it out. Both routes present expensive options that could cost you now and in the future.
However, there are some situations where it may be okay to tap into your retirement savings. Buying a business or having a qualifying financial hardship are great examples. These situations may allow you to get access to your funds without paying an early withdrawal fee.
Why You Shouldn’t Dip Into Your Retirement Account
What is the reason you’re looking to dip into your retirement funds? Has a hardship fallen upon you or your family? Are you starting a business that you’re confident about? If your goal is different, then the answer is likely that you shouldn’t dip into those funds. Here are three reasons why:
1. You’ll Need the Money Later
You’ve worked on establishing a retirement fund for a reason. You invested early in life so that you would be comfortable when you could no longer work. The future is full of unknowns, and being prepared sets you up a lot better than not having anything to fall back on.
For instance, the job market has become very shaky. Salaries do not always account for inflation and older workers are often out of luck when looking for even a part-time job. Not having retirement funds could cripple your ability to have the quality of life you desire when you hit retirement age.
Even if you have retirement funds, you may not have enough when the time comes if you start to dip into your retirement funds early. Many experts believe you need to save 10-20% of your income for retirement each year. Your social security income will barely cover a small piece of the amount you’ll need to live. That’s why it’s important to save every dollar you can while it’s in your retirement account.
2. You Lose Now and in the Future
Taking cash out of your 401k means losing any potential returns that amount of cash could earn from now until you retire. If you withdrew $10K out of your 401k, you’d be losing all the interest and earnings that would have been compounding into retirement.
For example, let’s look at what you could potentially lose if you withdrew $10K (not factoring taxes or fees) out of your 401k. Let’s say you withdrew funds at age 35 and missed out on a average annual return of 7%. That $10k withdrawal would have actually decreased the value of your retirement account by $76K (not adjusting for inflation) by the time you’re 65. That’s a $66K+ loss!
3. Taxes and Withdrawal Penalties
If you’re younger than 59 ½ and you’re trying to take money out of your retirement account, it could become very expensive. You may be able to borrow against your 401k, but make sure you pay it back in the time allotted. Otherwise, you’ll be charged a hefty penalty.
Typically, borrowing from a 401k allows you to receive up to half of your vested balance (up to $50K). And, you must pay it back in five years. You also must make interest payments on the loan until you pay it back. Borrowing from a Traditional IRA isn’t allowed, but you can get a 60 day rollover. In this situation, you can access the funds for a very short period of time.
If you decide to cash out your retirement account in order to get access to your retirement funds, you’ll pay a 10% penalty, plus taxes. Taxes can be as much as 20% or more. If you’ve borrowed against your account and you fail to pay the loan back on time, then your account goes into a withdrawal. Plus, you’ll owe these additional taxes and fees as well.
When It Might Be Okay to Tap Your Retirement Account
While the answer is generally “no” to tapping your retirement funds for any reason, there are three scenarios where it might make sense. Each of these scenarios gives you the ability to withdraw funds without paying taxes or penalties. While your funds will still be in danger of not being there when you need them, it makes financial sense to dip into your retirement under these circumstances.
1.If You Have a Roth IRA
Withdrawing from a Roth IRA is much easier and advantageous than from other retirement accounts. When you invest in your Roth IRA, expect taxation on your contributions. This way, you don’t have to pay taxes if you plan to be in a higher tax bracket when you withdraw during retirement.
Thanks to this requirement, you can withdraw your contributions from your Roth IRA account at any time. And, you can do so without paying taxes or penalties! However, cashing out your entire account early (before 59 ½) would still require you to pay taxes on any earnings you’ve had from your contributions. This is a good way to withdraw some funds from your retirement account without having to pay a bunch of extra money to do it.
2. If You’re Starting or Buying a Business
A rollover for business startups (ROBS) helps you roll your retirement funds from an eligible retirement account (401k, Traditional IRA) into a new business. You can use these funds to buy business assets, to start a franchise, or as a down payment for a business loan. One benefit of ROBS is not paying taxes or early withdrawal penalties for using the money in your new business.
ROBS are one of the best kept secrets to startup financing. Using ROBS to prevent the use of a loan can save the business a lot of money in interest and monthly loan payments. It opens up the business’s cash flow to business operations and growth.
All ROBS are closely monitored by both the Department of Labor (DOL) and the Internal Revenue Service (IRS). It’s important that you setup your ROBS correctly, and that you make sure you file the right information with the IRS every year. This is why it’s recommended that you partner with an experienced ROBS provider to help you along the way.
While ROBS can prevent the use of loans, they remain very controversial, and are a risky venture. One major risk to consider is the possibility of losing your entire retirement fund. Businesses often fail in the first 5 years and using ROBS could leave users with nothing for their future retirement.
3. If You Have a Great Hardship
Your retirement funds are typically protected from bad events, such as bankruptcy. If you dip into retirement funds early, it may lead to struggles when you hit retirement age. However, having a hardship is one scenario when you can take money out without incurring any early withdrawal fees.
The IRS sometimes allows you to withdraw funds from your retirement account tax and penalty free. But, it is only allowed if your needs are due to a qualifying hardship. Hardship scenarios include:
- Medical bills that exceed 7.5% of your adjusted gross income (AGI)
- Becoming totally and permanently disabled
- Paying health insurance premiums, if you’ve been unemployed for 12+ weeks
- If the IRS has levied a tax against your retirement account
- Higher education costs for you, your spouse, children, grandchildren, or other immediate family members
- First time home purchase costs (or if you haven’t owned a home in 2+ years)
You will typically pay income taxes on these withdrawal situations, but no additional fees. The higher education and home purchase scenarios may also cost you a withdrawal penalty if you’re taking funds from a 401k account. It’s best to check with a tax professional before moving forward with a hardship withdrawal.
You typically don’t want to dip into your retirement savings. Exceptions include doing it without paying withdrawal fees or borrowing against your account. When you withdraw funds from your retirement account you lose out on all of the money that it could have earned from now until you retire. Even if you fall on hard times, we do not recommend solving your problems by robbing from your future.
Instead of relying on retirement funds in an unexpected event, you could start an emergency fund. Try investing a portion of your income to an emergency fund every month. This way, your fund gives you disposable amounts of money to use when you’ve fallen on hard times. It enables you to steer clear of your retirement accounts, leaving them for later in life when you may not have any other income options.
Ian Atkins is an expert staff writer and financial analyst for Fit Small Business, with over 9 years of experience working in personal and small business finance.