What is the Cost of Withdrawing Funds Early From Your Retirement Plan?

It’s generally a bad sign when people start to dip into their retirement plans to pay bills, college tuition, or some other urgent expense. Despite this, more workers have been borrowing from their accounts or taking hardship withdrawals in recent years.

 As 2010 drew to a close, 28% of active 401(k) participants had outstanding account loans, and another 7% took early withdrawals. Then, during 2011, retirement savings account loans rose by 20% across all groups of people.

While understandable that people might turn to their retirement accounts for a source of immediate cash, it is rarely a good idea. 55% of employees who took a cash distribution when changing jobs said they regretted having done it.

Your Money Needs to Work For You

With certain exceptions, a 10% federal income tax penalty applies to early withdrawals (before age 59.5) from tax-deferred plans such as IRAs and employer-sponsored retirement plans. Though a significant deterrent in itself, the greater penalty lies in the potential loss of future earnings. These are gains that often make a crucial difference when the time comes for retirement.

Consider the impact of a $10,000 early withdrawal from a traditional IRA...

Not only could the distribution be subject to the penalty ($1000) but also to income taxes ($2800 for someone in the 28% tax bracket), which could leave a net amount of $6200. On the other hand, if the $10,000 principal was left in the tax-deferred account, in 20 years it would have the potential to more than triple, assuming a 6% average annual return; in 30 years, it might reach $60,000. Although a hypothetical analysis, the scenario can be used to judge the impact on your own retirement funds. 

If you change jobs, you may be able to leave your retirement account assets in your former employer’s plan. Another option is to roll the assets to a traditional IRA. A properly executed trustee-to-trustee transfer to your own IRA could help preserve the tax-deferred status of the funds and potentially avoid unwanted current tax consequences and penalties.

This can also give you more control of the assets, open up additional investment options, and help you to manage overhead costs.

Exceptional Circumstances

If life deals you a bad hand, or you have other reasons to access your retirement funds earlier than planned, there are circumstances in which the penalty is waived on early withdrawals before age 59.5 (distributions remain subject to ordinary income tax, however):

• Your death or permanent disability,

• A series of substantially equal periodic payments (based on life expectancy) from an IRA or a former employer’s plan that continue for at least five years or until age 59.5, whichever occurs later,

• Payment of unreimbursed medical expenses that exceed 10% of adjusted gross income (in 2013),

• Employer plans only: If you are at least age 55 when you terminate or sever employment (or turn 55 by December 31 of the same year), all distributions avoid the penalty,

• IRAs only: The penalty is waived when the funds are used for qualified higher-education expenses or a first-time home purchase ($10,000 lifetime maximum).

If you take an early withdrawal from a tax-advantaged retirement account, you may well lose the opportunity for that money to continue growing on a tax-deferred basis. Consequently, your plan may then fall short of meeting your retirement income needs.

Have you had to take an early withdrawal or adjust your retirement planning?

If so, what impact has it had on your plans?