Due to the pandemic, more people are wondering whether they should withdraw funds from a 401k or IRA to help pay for life. There are plenty of reasons to withdraw money from a 401k or IRA. Unfortunately, some people go too far and end up using their 401k or IRA like a checking account instead of as a retirement account.
Withdrawing funds early from a 401k or IRA is like constantly picking at a scab. The more you do it, the slower your wound will heal. Pick it too often and the wound might actually begin to fester and result in a potential amputation (terrible retirement).
Once you start withdrawing from your 401k or IRA early to pay for things, you may come to rely on your retirement funds as a crutch. As a result, you may never end up building a strong third leg for your retirement stool.
In general, treat your 401k and IRA like a black hole where money only goes in and never comes out. Then work to build your after-tax investment accounts in order to generate passive income.
Of course, if you are facing a life or death situation and the funds in your 401k or IRA are all you have, then withdraw what you need.
CARES Act Changes Withdrawal Rules For 401k And IRA
The rules regarding the withdrawal of funds from a 401k and IRA are somewhat complicated. They are also constantly changing. If you find any errors, please feel free to let me know so I can correct them.
Normally, if you withdraw money from a traditional IRA or 401k before reaching age 59 ½, you have to pay a 10 percent early withdrawal penalty.
In addition, emergency withdrawals from your current employer-provided plans are limited to a set of approved hardships. These may include avoiding foreclosure, home repairs after a disaster, or medical expenses.
However, thanks to the CARES Act, the 10 percent early withdrawal penalty is temporarily no more in 2020 if the pandemic has negatively affected your finances, e.g. furloughed, laid off, hours cut, unable to work due to lack of child care, etc.
One-third of the money you withdraw will be counted as income in your taxes for each of the next three years unless you elect otherwise. The CARES Act also allows you to pay back what you withdrew from your accounts if you’re able to do so.
How Much Can You Withdraw From A 401k Or IRA?
Before the pandemic, according to the IRS, the maximum amount that the retirement plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
For example, if you have a 401k balance of $40,000, the maximum amount that you can borrow from the account is $20,000.
After the CARES Act passed, you are now allowed withdrawals of up to $100,000 per person taken in 2020 to be exempt from the 10 percent penalty. You can’t get the special tax and CARES Act treatments for withdrawn amounts greater than $100,000 in total across all of your accounts.
The CARES Act also eliminates the 20 percent automatic withholding that is used as an advance payment on the taxes that you may owe on employer-provided plans like your 401k.
Just know that hardship withdrawals are still subject to income taxes. Since your savings went into your retirement plan on a pretax basis, you’ll be paying income taxes on the contributions and earnings withdrawn.
You then get a three-year period to pay the taxes to the IRS. However, if you pay the distribution back within three years, you can file for a refund of the taxes you paid on that distribution.
Legitimate Reasons To Withdraw Funds From A 401k Or IRA
Now let’s go through the most legitimate reasons for withdrawing funds from a 401k or IRA. (Note: For withdrawals made during the pandemic, I’m assuming that the main withdrawal reason is to pay for daily living expenses.) Some of these withdrawals are penalty-free, some are not. Always double check with you HR department.
You are allowed to take an IRA distribution for qualified higher education expenses, such as tuition, books, fees, and supplies. This distribution is still subject to income tax, but there is no withdrawal penalty.
For instance, if you want to get an MBA, you can tap your retirement fund for tuition. The rule also allows you to use this exception for your spouse, children, or their descendants as well. Keep in mind this exception is for IRAs only. 401ks or other Qualified Plans are subject to a different ruleset.
Specifically, some 401k plans will allow what is called a “hardship withdrawal,” with education expenses sometimes falling under this clause. Expenses eligible for a hardship withdrawal will vary depending on your 401k plan administrator. Therefore, make sure you ask first before withdrawing. Some providers do not allow hardship withdrawals at all.
Withdrawals from your 401k to pay for education are subject to a 10 percent penalty.
To use your pre-tax retirement accounts to pay for an overpriced education that is rapidly depreciating in value may be a poor financial decision.
Instead, I suggest getting extra education part-time during the evenings or weekends. Better yet, get your employer to pay. Although it was a PITA for three years, I’m glad I was able to get my MBA part-time between 2003-2006. My employer ended up paying 80% of the tuition, or roughly $70,000 without me losing any career progress.
2) First-Time Home Purchase
You can take up to $10,000 out of your IRA penalty-free for a first-time home purchase. If you are married, your spouse can do the same for a total of $20,000.
Just like the education exclusion, you can also tap this option for the benefit of your family. Your children, parents, or other qualified relatives may receive the same $10,000 for their purchases. This is even if you’ve used this benefit for yourself previously or already own a home.
There’s no specific penalty exemption for first-time home purchases when you pull money out of a 401k. Technically, you’re making a hardship withdrawal to buy your first home. However, it is doubtful buying a first home would be considered a hardship.
Therefore, you are likely to incur a 10 percent penalty on the amount you withdraw from your 401k unless you meet very stringent rules for an exemption. Even then, you will still owe income taxes on the amount withdrawn.
Withdrawing from your pre-tax retirement accounts to borrow money from a bank in order to buy your first home is risky. Such a move could wipe away your entire net worth in a few short years if the real estate market turns south and you’ve got to sell. Besides, paying a 10 percent penalty shouldn’t sit well with you.
Instead, you’re much better off building your savings and taxable investment portfolio that can provide for a 20% down payment. If you don’t have at least a 20% down payment in cash plus a 10% buffer, you probably cannot comfortably afford to buy your first home.
Renting is good value now in many big cities. Please keep your pre-tax retirement accounts and your real estate investments separate.
3) Family Circumstances
If you are required by a court to provide funds to a divorced spouse, children, or dependents, the 10 percent penalty can be waived.
Contentious divorces happen all the time. We must follow the court rules, otherwise, we may get into bigger trouble. As parents, we should always support our kids until they become adults. I’m not so sure the same can be said about ex-spouses.
4) Medical Expenses Or Insurance
If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you can pay for them out of an IRA without incurring a penalty.
For a 401k withdrawal, if your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year, then the penalty will likely be waived.
In my opinion, a surprise medical expense is the most legitimate reason for withdrawing early from a 401k or an IRA. Nobody goes through life wanting to get a surprise medical expense beyond the cost of what insurance covers.
Medical expenses are often unforeseeable and can be extraordinarily expensive without sufficient insurance.
Series of Substantially Equal Payments
If none of the above exceptions match your individual circumstances, you can consider taking distributions from your IRA or 401k without penalty at any age before 59 ½ by taking a 72t early distribution.
The amount of these payments is based on a calculation involving your current age and the size of your retirement account. Visit the IRS’ website for more details.
The catch is that once you start, you have to continue taking the periodic payments for five years, or until you reach age 59 ½, whichever is longer. Also, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!
The 401k Loan Is A Better Option
If you have to pay a 10 percent penalty on a withdrawal, then a better solution is to borrow against your 401k and pay yourself back. A 401k loan does not have a 10 percent penalty. If your plan allows loans, your employer sets the terms.
Before the CARES Act, the maximum loan amount permitted by the IRS was $50,000 or half of your 401k’s vested account balance, whichever is less. During the loan, you pay principal and interest to yourself at a couple points above the prime rate, which comes out of your paycheck on an after-tax basis.
Under the CARES Act, you can now borrow up to $100,000 of your 401(k) balance, with up to six years to pay yourself back for the loan. In this scenario, you do not accrue any tax liability. And as you pay back the loan, those amounts get reinvested faster than if you delay paying the tax liability on a distribution. The interest rate for a 401k loan is generally between 2.5% – 6.5%.
Just remember that the CARES Act pertains only to 2020 so far. I assume the rules will revert to the way they were pre-CARES in 2021 and beyond.
Borrowing from your 401k is a good alternative because you do not need a credit check, nothing appears on your credit report, and interest is paid to you instead of a bank or credit card company.
But again, if you habitually borrow from your 401k, you’ll likely never be able to save enough in your 401k for retirement.
Motivation To Not Withdraw Funds From A 401k
Every time you’re tempted to borrow from your 401k, take a look at this chart below. It shows you when you will become a 401k millionaire based on various portfolio allocations and return assumptions.
Not only is paying a 10 percent penalty painful for a hardship withdrawal, so is losing out on years of compounding.
IRA Rollover Bridge Loan
There is one final way to “borrow” from your 401k or IRA on a short-term basis: roll it over into a different IRA. You are allowed to do this once in a 12-month period. When you roll an account over, the money is not due in the new retirement account for 60 days. During that period, you can do whatever you want with the cash.
However, if the entire amount is not safely deposited in an IRA when the time is up, the IRS will consider it an early distribution and you will be subject to penalties on the full amount.
This is a risky move and is not generally recommended. But if you want an interest-free bridge loan and are sure you can pay it back, it’s an option.
Withdraw Money From Different Accounts First
Given 401k and IRA contributions are pre-tax contributions, from the government’s point of view it makes sense there should be penalties assessed for early withdrawals.
The IRS doesn’t like that you haven’t paid taxes on your contributions and received the benefits of tax-free compounding, yet still want to withdraw funds for some random expense you don’t need.
The better practice is to go through the following succession of fund pilfering:
- After-tax investments
- Side job income
- Borrow money interest-free from a friend or family member
- Cajole your parents into giving you some of your inheritance today
- Take out a personal loan with an interest rate under 10%
- Roth IRA
- 401k or IRA
With the Roth IRA, since you’ve already paid taxes on your contributions, you can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA if you’ve held for less than five years.
After you’ve held the account for five years, you can withdraw up to $10,000 in earnings without penalty or tax for the purchase, repair, or remodel of a first home. In other words, you can withdraw all of your contributions plus another $10,000 from earnings and not pay the 10% penalty or taxes on any of it.
There is one caveat, however: you only have 120 days to spend the withdrawal or you may be liable for paying the 10% penalty. Also, for your convenience, your financial services firm should be able to automatically prioritize the withdrawal of all of your contributions from a Roth IRA before any earnings.
Try Not To Touch Your 401k Or IRA
It may be tempting to withdraw funds from a 401k or IRA to pay for a car or a fancy vacation. If you do, however, you’re just hurting your retirement. It’s much better to pay for superfluous things through other sources.
Hopefully, you never reach the point where you have to consider withdrawing funds early from a 401k or IRA for a necessity, even without a 10 percent penalty.
Continuously build your financial buffers. The more you have, the more protected your 401k or IRA will be. When you finally retire, you will be happy that you left your funds untouched all those years.
Readers, what are some other reasons for withdrawing early from a 401k or IRA? Have you ever had to withdraw early from a 401k or IRA? If so, what were the reasons and why didn’t you take out a 401k loan instead?
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