Retirement Savings Withdrawals vs Loans
At some point, you may find yourself needing extra cash because of financial hardship or a life change such as a down payment on a home. You may have considered using your retirement savings for this purpose, but this decision shouldn’t be taken lightly. Two ways to get money from defined contribution plans before reaching retirement age include loans and withdrawals.
There are key differences between these two options, some of which could have major financial consequences or penalties. Knowing the difference can help you make the wisest choice for your financial situation. Your choice will affect future savings goals. Keep in mind that your specific retirement plan will have rules for withdrawals and loans. Discuss these options with your provider before making a decision.
Retirement Savings Withdrawals
Withdrawing money from your retirement savings should be a last resort. Why? You may lose a significant amount in potential earned interest as well as pay taxes and penalties if you withdraw before retirement age. Ultimately, the amount you withdraw could cost you a lot in retirement savings in the long run.
Let’s look at an example of a 29-year-old woman who makes $50,000 per year. Her 401(k) plan account balance currently averages 3% annual growth, and she is in the 12% tax bracket. If she withdrew $10,000 from her retirement savings account, she would pay a $1,000 early withdrawal tax penalty and $1,200 in taxes. This would reduce the cash amount in your pocket to $7,800. If she plans to retire at 65, a loss of $10,000 from her 401(k) plan account would cause a loss of $28,983 in potential future retirement benefits! 1 Take these losses into consideration before you take a withdrawal from your account – no matter how small!
Understanding Hardship Withdrawals
If you decide an in-service withdrawal is your only option, there are some situations where the Internal Revenue Service (IRS) could waive the tax penalty for an early withdrawal. You will still have to pay income tax on the amount withdrawn, but the 10% tax penalty will be waived. For 401(k) and 403(b) plan savings accounts, the IRS offers six main categories for hardship withdrawals.
For hardship withdrawals, the order of your actions is very important. In certain circumstances, you need to apply for the hardship withdrawal before paying for one of the above circumstances. For example, if you are withdrawing for medical care expenses but you had already paid the bills with a credit card, this is no longer considered a medical expense, but rather a credit card bill. In this case, the hardship withdrawal may be denied, and the tax penalty would apply.
Be sure to speak with your retirement savings provider to understand the requirements and consequences for any withdrawals from your plan.
Retirement Savings Loans
While taking any amount from your retirement savings still has financial consequences, a loan could be less detrimental to your future savings amount than an in-service withdrawal.
For most plans, you are typically allowed to take up to 50% of your total account balance up to $50,000.2 Most plans offer a five-year maximum payment plan at a reasonable interest rate similar to a commercial loan, and these payments are taken from your paycheck post-tax. Because the loan is essentially from yourself instead of a financial institution, the loan interest is paid to your retirement plan account.
When you take out a retirement plan loan, you do not pay income tax unless you decide not to pay back the loan by the end of the payment plan. You also are not subject to early withdrawal tax penalties. However, if you do not pay the loan back, you could end up paying tax on the unpaid amount twice.
So, why wouldn’t people take retirement plan loans more often? There are still financial consequences to consider. First, you will lose any market earnings you might gain on the amount you loaned while it is out of your account. Over time, the lost potential growth compounds, so the faster you pay off the loan, the less potential growth you will lose. Second, if you leave your place of employment while you have a balance on the loan, you will likely be required to pay it in full upon termination.
If you are considering a loan or withdrawal, speak to your retirement plan administrator before making any decisions. Also, consider reaching out to a professional financial advisor to make the best decision for your finances and future.
This blog is up to date as of July 2020 and has not been updated for changes in the law, administration or current events.