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Should You Withdraw Money From Your 401(k) or IRA?

Should You Withdraw Money From Your 401(k) or IRA?

The Money Tea
  • Historically, when markets rebound after a downturn, it typically happens fast. If you tap into your retirement funds, you may prevent yourself from benefiting over the long haul.
  • If you need emergency cash and your 401(k) is your only source of funds at this unprecedented time, then taking a short-term loan from your retirement account as a last resort may be a viable option.

As part of the CARES Act, investors impacted by coronavirus of any age can withdraw as much as $100,000 from retirement accounts including 401(k) plans and individual retirement accounts (IRA) this year without paying an early withdrawal penalty of 10%.

Perhaps you’re currently facing economic hardship as a result of being furloughed or laid-off and this provision appeals to you. But should you really take advantage of this provision? What are some factors to take into consideration?

CARES Act Quick Recap 

Typically, it is not advised to withdraw from your retirement account because of various penalties. The penalty for withdrawing from a 401(k) before turning 59½ years is 10% of the distribution, plus an automatic withholding of at least 20% for taxes. But with the passage of the CARES Act, that all changes in 2020. 

You can avoid taxes on the withdrawal if the money is put back in the account within three years. If it isn’t returned, taxes can be paid over a three-year span. Additionally, loan repayments from workplace retirement plans may be delayed for one year (in effect through the end of 2020). In summary:

If you take a withdrawal:
  • You are not required to repay.
  • There’s no withdrawal penalty.
  • It will be taxed as income initially, but if you pay back the distribution within three year, you can claim a refund.
  • You have tax options.
If you take a loan:
  • You are required to pay within a specified time frame, typically five years.
  • The loan amount will not taxed initially, and there is no penalty. However, if you can’t pay it back in five years, the outstanding balance will be taxed as if it were a withdrawal, and you will also pay the 10% early withdrawal penalty.
  • All loan payments due in 2020 can be delayed for up to one year from the time you take out the loan.
  • If you leave your job, you have until mid-October of the following year to pay back the entirety of the loan. If you do not pay it back, you will be hit with early withdrawal taxes and penalties.

Although withdrawing from your 401(k) or IRA might be appealing, there are a few factors to keep in mind.

Every dollar you take from your 401(k) or IRA today means you will have less in retirement.
You May Be Hurting Your Retirement

Did you know that every dollar you take from your 401(k) or IRA today means you will have less in retirement? Yes, this is thanks to the power of compound interest.

For example, you have $30,000 in your 401(k), and take a $5,000 penalty-free distribution. If you don’t pay it back, not only will you forgo the tax refund, you will miss out on substantial long-term growth.

In this case, $30,000 could grow to about $172,300 after 30 years without any additional contributions. Conversely, $25,000 might only grow to about $143,600. So, the $5,000 you withdrew would cost you about $29,000 in the long term!

Historically, when markets rebound after a downturn, it typically happens fast. If you tap into your retirement funds, you may prevent yourself from benefiting over the long haul. 

Don’t Forget That Time is on Your Side

It’s only natural to be anxious about investing. But don’t forget that if you’re young, you have 20, 30, 40 years to make back what’s happened. Your best action is to create an investment policy to determine how much they should have allocated to risky assets and to safe assets. The amount of risk you take depends on your time horizon, ability to save and psychological ability to take risk. Once you create an investment policy, assets should be rebalanced to fit the investment policy.

If you tap into your retirement funds, you may prevent yourself from benefiting over the long haul.
Consider A Short-Term Loan From Your 401(k) or IRA Instead

However, if you need emergency cash and your 401(k) is your only source of funds at this unprecedented time, then taking a short-term loan from your retirement account as a last resort may be a viable option. This is because technically, you would be paying yourself back (interest-free) instead of paying 11% interest on average on a personal loan. Other reasons to take a short-term loan from your retirement include:

  • To avoid a housing problem. If your bank or landlord hasn’t put any rent or mortgage relief plans in place, it could be advantageous to continue paying these with retirement funds if you’re at risk of eviction or foreclosure and have no other savings.
  • To meet other basic needs. If you don’t have an emergency fund in a non-retirement savings account, it may make sense to tap into retirement accounts to pay for medical emergencies, prescriptions, essential food and hygiene items for you and your family, or elder care.
Final Verdict?

Although you can now withdraw from your 401k or IRA penalty-free, experts recommend not touching your savings until retirement. Compounding is a huge help when it comes to maximizing your retirement savings and extending the life of your portfolio, and you lose out on that when you take early distributions. 

See Also

However, if you absolutely have no other choice, consider taking a short-term loan from your retirement account. While a loan will cost more because interest is charged on the amount borrowed, at least repayment is guaranteed.

$30,000 could grow to about $172,300 after 30 years without any additional contributions, whereas $25,000 might only grow to about $143,600.

Additionally, even though taking a penalty-free withdrawal from the 401(k) is appealing because it won’t cost you as much, can be hard psychologically to take from yourself and pay yourself back. It might be better to borrow the money because you will have a regular bill to pay and the cost is immediate. And your retirement remains funded.

If you do decide to withdraw, the key to minimizing the downside is to only take out what’s absolutely necessary and pay back the amount within three years — though the sooner you can pay it back, the better.

 

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