Don't tap retirement funds too soon

Piggy BankA 401(k) plan should never be viewed as a pre-retirement piggy bank. Unfortunately, more and more savers tap retirement accounts prior to their retirement. In fact, a recent study by financial services firm TIAA-CREF shows that nearly one-third (29 percent) of Americans who participate in a retirement plan say they have taken out a loan from their plan. Additionally, of those who took out a loan, approximately 43 percent have taken out two or more loans.

To make matters worse, account holders sometimes choose to liquidate their funds altogether rather than borrow against their account, often resulting in significant taxes and penalties. While financial hardships do arise and some participants simply have no choice but to access funds meant for their future, others choose to withdraw retirement accounts without a thorough understanding of the financial repercussions.

Accessing a retirement account early may sound like an easy fix for financial issues. However, according to TIAA-CREF survey results, nearly half of those who have borrowed against their retirement plan savings end up regretting the decision. If so many savers wish they never withdrew from their accounts, why did they choose to do it in the first place? Unfortunately, many savers choose to withdraw funds for the wrong reasons. Financing an auto purchase, installing a new kitchen or building a swimming pool are simply the wrong reasons for taking out money. On the other hand, some financial issues are significantly more serious. From paying for a financial emergency like health care expenses to addressing bills in the event of a job loss, there are many unavoidable money issues that can arise.

Consider exhausting all other options prior to withdrawing from your plan. Depending on the circumstances, low interest home equity lines of credit (HELOC), home equity loans, 0 percent credit cards or even borrowing from a family member may all be better options than taking funds from your retirement account. Remember, taking money from your retirement account is really borrowing against your future goals. If you truly have determined that there are no other feasible options to address your financial emergency, considering a loan may be necessary.

If your retirement plan/401(k) provider allows for it, a loan of 50 percent of the value up to a maximum of $50,000 can be taken. Since it is a loan and not a pre-age 59½ distribution, the usual 10 percent penalty and tax on the distribution will not be assessed as long as the account is paid back. The interest being charged is paid back to yourself through payroll deductions on an after-tax basis — usually over a period of five years. The interest rate charged is usually one to two percentage points greater than the prime lending rate but again, you are paying yourself. Keep in mind that you cannot borrow money from an IRA. While there are certainly some advantages to a 401(k) loan, there are also some disadvantages too.

First, any funds that you have removed from your retirement account to lend yourself are no longer invested and working for you. Fewer funds invested may mean that your retirement account could realize less tax-deferred growth over time. Additionally, loans often lead participants to reduce their future contributions since they may struggle to afford their regular 401(k) contributions while also paying back their 401(k) loan.

In fact, according to the TIAA-CREF survey, 57 percent of respondents reduced their retirement contributions during the loan payback period. Also keep in mind, if you are saving on a pre-tax basis, your contributions would normally help reduce your current tax liability. If you reduce your pre-tax contributions, you could be increasing your tax bill too.

Next, let’s examine the true cost of the loan. While repaying yourself with interest may sound attractive, it is important to note that the actual cost of the loan is bit higher than it may seem. Despite the fact that the interest payments to yourself are deposited into your plan with after-tax funds, you still pay tax on the interest payments at retirement when they are withdrawn. This can result in a double taxation of the interest payments. That’s right — you are actually paying taxes twice on the interest. While this does not increase the cost significantly, it is important to be aware that your loan cost is a bit higher than advertised.

Finally, there are significant repercussions to leaving your job while having an outstanding loan. Should you leave your employer for any reason before your loan is paid, you generally have only 60 days to pay back the loan in full — not much time. In the event that you are unable to pay back the loan, the loan is fully taxable and could be subject to a 10 percent early withdrawal penalty if you are younger than age 59½. With so many workers job-jumping, this is one of the most significant drawbacks to borrowing against your account.

Bottom line — Borrowing against your retirement account may lead to penalties, taxes and less money saved for retirement. While utilizing a 401(k) loan may not be ideal, it is generally better than cashing out your account all together. Consider reviewing all alternatives prior to tapping into your retirement account. Since everyone’s situation is unique, consider speaking to your tax, legal and financial advisers to determine the most appropriate distribution approach for you.


Kurt J. Rossi, MBA, is a Certified Financial Planner Practitioner and Wealth Advisor.
He can be reached for questions at (732) 280-7550, or LPL Financial Member FINRA/SIPC