Back in November, I spotlighted a letter from a reader who agonized over a debt dilemma that involved his retirement savings. “Nick from Michigan” wanted to tap his 401(k) to pay off $12,000 in credit card debt, but couldn’t pull the trigger. I talked to a few financial experts who all said the same thing: “Don’t do it, Nick!” You can read that original column by clicking here.
While the advice had a certain finality to it, I’m the kind of finance writer who’s fascinated by the exceptions in life. Recently, a close relative who had lost his job had to tap his retirement account to pay off bills, and he sounded unrepentant. “I have to keep a roof over my head, and this is my best option,” he told me.
That got me thinking: Are there ever times when it’s permissible, or even advisable, to go for money in a retirement fund as opposed to some other option? This question can’t be treated lightly, as any withdrawal from a 401(k) that isn’t repaid incurs a sizable tax penalty: 10% additional tax over what you owe for the original taxes on the earnings, according to the I.R.S.
To explore this topic further, I contacted Eleanor Blayney, the consumer advocate for the Certified Financial Planner Board of Standards. As a financial planner for more than 20 years, she’s seen plenty, and graciously offered her views on when to consider an early withdrawal from retirement accounts.
Not all retirement accounts are alike
First off, you need to know the difference between a 410(k) and an individual retirement account (or IRA). Simply put, a 401(k) is offered through your place of work and involves your contributions (often matched or supplemented by your employer). An IRA is a private investment funded solely by your own money. “It can be a bit more difficult, and in some cases costly to take money from a 401(k) plan, if you are still working,” Blayney notes.
But what if you have to take money out, or feel compelled to do so? Blayney lists a number of circumstances when tapping or leveraging retirement funds might be a possibility.
Taking a loan from your retirement account
Before you yank money out of your retirement account, consider a loan on your 410(k). “Loans are limited to a certain amount — up to the lesser of $50,000 or 50 percent of account balance, and you have to pay it back generally within five years,” Blayney says. You’ll get more time if proceeds are used for home purchase, and in general you’ll pay interest at a rate generally a percentage point or two above prime. “This means that your 401(k) is not generally a better source of funds than a bank mortgage, which currently will be cheaper,” Blayney says.
A 60-day liquidity squeeze
If you can pay the funds back to your retirement account within 60 days, you can tap those funds without any penalty. But the key here is that you have to pay back within those 60 days, or face the tax consequences. “Let’s say you are between buying a home and selling a home with signed contract in hand,” Blayney says. “You can take the needed funds as a withdrawal from an IRA. But why is it you don’t have an emergency fund set up to take care of these kinds of things?”
No or little taxable income
If you’ve had a particularly brutal year financially, you might take money from your IRA and still find that you fall below the threshold for taxable income, or a significant amount of tax to pay. “But you’ll still have a 10 percent penalty to pay if you are under 59 1/2,” Blayney says.
Your financial planner says it’s OK
Blayney recommends you discuss all your options with a CFP first before making any brash moves. It is possible, she says, that they’ll agree that it’s OK to tap retirement funds — but not without a solid plan to avoid doing so in the future. “He or she might agree that this is your best option for the time being,” Blayney says. “But they’ll also want to work with you to ensure that you rebuild your retirement account, get an emergency fund in place and establish good credit.”
It’s sad to say, but there may come a point when your life is on the line, and the issue of retirement takes a back seat to getting the medical help you need. In that case, you could tap funds “if you are terminally ill, need money for medical expenses, and are not expected to live to retirement age,” Blayney says. “This last example should bring home the overall point that borrowing from your retirement accounts is truly the very last thing you should ever consider.”
Parting shot: “Don’t attempt this at home”
It’s possible that Nick from Michigan, or others reading this, still find the prospect of tapping a 401(k) or retirement account tempting, especially if you have debt hanging around your neck like an albatross. We’ve said it before here, and Blayney will say it again as our last word on the subject:
“When it comes to taking money out of an IRA or 401(k), I’m always reminded of the TV commercials showing stunts men or racing car drivers that warn “DON’T ATTEMPT THIS AT HOME! Yes, it might seem like taking money from your retirement account is an easy, even attractive, thing to do — after all it’s your money, right? But there are many pitfalls and adverse consequences for the unwary, and it is imperative that anyone considering this, first talk to a competent qualified professional — a CFP professional — before doing this.”