If you’ve been saving regularly, you’ve likely built up a decent nest egg in your retirement plan. When you’ve got some hefty bills coming your way, it might be tempting to cash out some of your savings. Is this a good idea?
Well, it really depends on a few different factors. There are costs to taking money out of a retirement plan, including extra retirement plan taxes. There are a few different ways to get money out of a retirement plan early and some moves are a lot less costly than others. We’ve ranked these moves from best to worst as well as explain their costs so you can decide if you really want to take money out of your retirement plan.
Option 1 – Loans from a work plan
If your money is in a work-retirement plan like a 401(k) or 403(b), you might be able to take money out through a loan. It depends on whether your employer set the plan up with this option. If your plan allows loans, you should be able to borrow up to 50 percent of your vested account balance up to a maximum of $50,000. Vested means the money is yours unconditionally. If your employer gives you matching contributions, you might have to stay at the company a minimum number of years before that money becomes yours, so you can’t borrow that money in a loan.
Once you take out borrowed money, you set up a payment plan of up to five years and pay the money back with a set interest rate into your retirement plan. This option is only available with work plans. IRAs don’t allow loans.
Work plan loans are a nice option for a couple reasons. First, you aren’t technically making a withdrawal so you won’t owe any extra taxes or penalties to the IRS. Also, since you’re paying yourself the money back with interest, you won’t lose too much ground on your retirement plan. You’ll be adding all the money back with a little bit of a return. You just have to make sure to pay the money back on schedule. Otherwise, the IRS will reclassify the move as a withdrawal and you’ll owe the extra retirement plan taxes, which we’ll discuss shortly.
Option 2 – A basis withdrawal from a Roth IRA
When you invest in a Roth IRA, you’re investing after-tax money into the account. Since you’ve already paid taxes on this money, the IRS lets you take out your contributions without charging any more taxes or penalties. Once you’ve taken out every dollar of your contributions, you’ll start taking out your investment earnings, which will be taxed. For example, if you’ve added $50,000 to your Roth IRA and have a balance of $70,000, you can take out $50,000 before facing any tax consequences.
This is another decent way to take money out of your retirement plans because you avoid all taxes and penalties. The downside of this approach is that it can push back your retirement goals because it’s not as easy to pay the money back into your plan. That’s because the annual contribution limit, currently $5,500, stays the same whether you take money out or not. Let’s say you take $20,000 of basis out of your Roth IRA to buy a car. It’s going to take you four years of contributions to pay that money all back into your plan.
Option 3 – Non-penalized retirement plan withdrawals
If you’re younger than 59 1/2 and want to take money out of a Traditional IRA/401(k) or want to take your investment earnings out of a Roth IRA, you’re making an early withdrawal. The tax impact of this move depends on why you’re taking out the money. There are a few situations when you can take out money and not owe an extra penalty. This includes if you were to become totally disabled, if you have excess medical bills that are more than 7 1/2 percent of your adjusted gross income, if you’re unemployed and need to pay your health insurance premiums, if you owe taxes to the IRS, and if you want to pay higher education expenses for yourself or an immediate family member. With the IRA, you can also take out up to $10,000 penalty-free to buy your first house.
You’ll owe income tax on all these withdrawals so it is a bit of an expensive source of money. For example, if you’re in a 25 percent income tax bracket, every dollar you take out for a non-penalized withdrawal will lead to an extra 25 cents in taxes that year.
Option 4 – Penalized withdrawals
If you want to make an early withdrawal for any other reason, for example, if you want to buy a car or an engagement ring, you can, but it will be even more expensive. You’ll owe income tax and an extra 10 percent penalty on the money you take out. Let’s say you want to take out $10,000 to pay off your credit card bills and you’re in a 25 percent tax bracket. To get this $10,000, you’re going to have to pay another $3,500 to the IRS that year. That’s about two years of interest on your credit card. Now, this isn’t to say that you should never make a penalized withdrawal. Sometimes, you just don’t have a choice. Just be aware that it’s a costly move and one that you shouldn’t make unless you have to.
Hopefully, with good budgeting and a solid emergency fund you’ll never have to tap into your retirement accounts. If you do though, keep this information in mind so you can prepare for any retirement plan taxes that come your way.