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Thinking About Cashing Out of a Retirement Account Early? Think Again

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

When the need for extra cash arises, retirement accounts can be easy targets to turn to in a pinch. Consider that almost one-third of participants say they have taken a loan against their plan savings, according to Natixis Global Asset Management’s 2016 survey of U.S. Defined Contribution Plan Participants. Another 28 percent reported having taken a withdrawal from their retirement plan—including 41 percent of Millennials.

Certainly, there are numerous reasons investors may find themselves in a temporary cash crunch. Top reasons for taking funds from a retirement savings plan include financial hardship, health care expenses, the need to pay down debt and home repairs. Despite investors’ willingness to use their retirement funds early, these accounts should only be tapped as a last resort—for multiple reasons.

First off, many people don’t realize that early withdrawals from their workplace retirement plan (before age 59½) can have serious financial consequences. For example, you’re likely to incur a 10 percent IRS penalty. There are some limited exceptions, of course, like making college payments or paying medical expenses that are deductible on your tax return. You may also be able to avoid the penalty if you suddenly become disabled or if you need up to $10,000 to pay for your first home.

But even if you avoid the penalty, you won’t escape paying ordinary state and federal income taxes on your withdrawal. What’s more, you’ll miss out on the opportunity for tax-deferred growth. And with less money in the account, you’ll diminish the power of compounding, which helps your money grow over time.

We’ve also had clients ask us about borrowing funds from their IRA, which we also advise against for similar reasons. Although you can’t officially take a loan from an IRA, there are ways to use your IRA assets for up to 60 days without incurring penalties. However, the IRS rules are strict, and we believe there are better options for securing short-term cash.

A growing number of investors are also using a job change as an opportunity to take cash out of their 401(k). Consider Fidelity data showing that one in three 401(k) investors has cashed out of his or her plan before reaching age 59½. This, too, is usually a bad idea. Not only will you deplete a good portion of your savings because of penalties and taxes. Once you withdraw these funds, the money is gone and it can be very difficult to replace. While it’s true that younger investors have more time to make up the difference, we strongly recommend investors consider other cash-generating options first.

One idea might be an unsecured loan from a peer-to-peer lender, family member, bank or credit union. Credit cards also offer cash advance options at varying rates.

As protection against short-term cash issues, we encourage our clients to maintain an emergency fund with cash reserves on hand to last at least six months—possibly more, depending on the situation. In this way, you won’t feel as pressured to draw from your retirement accounts if the need for cash suddenly arises.

At Align, we understand that unexpected situations sometimes arise and adjustments may need to be made to your long-term plan. We work closely with you to help you meet your short-term funding needs, while preserving your long-term savings. Please don’t hesitate to reach out to discuss further how we can best assist you.