Balancing long term and short term financial goals can be difficult – something always pops up. Whether it’s debt, a major purchase, or an unexpected expense, it can be tempting to dip into your retirement savings for the cash to take care of your new expense. The problem is unless you are at retirement age, you actually don’t get the amount that is in your retirement account because taxes and penalties will eat up a large portion of that. You are also hurting your long term financial plans.
So should you make an early withdrawal from your retirement funds to pay down debt, finish a home improvement project, or take care of another expense? Let’s look at a situation and see how it works.
I am a self employed carpenter in a time when there isn’t much worse to be. I had started an addition to my home of 1500 sq ft. and got to the point of being within about 12 grand of finishing it. I can use the square footage to get a refi that would lower the overall payment quite a bit and pay off a card or two except that the house has to be finished to count.
I have a self employed retirement account with about 8000. in it. I have been in this account for about two years and am down about 800 bucks. In other words, no gains. I think that the prior account was a loser for me also. I want to take all but a grand out to finish the addition so I can get the refi loan which may save me near 600 a month. Will I have to pay fines on no gains? If so, would it be worth it to take the fines as the savings will be so good on the new refi?
Thanks, Peter
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Should I Make an Early Withdrawal from My Retirement Account?
Peter, great question. Refinancing your mortgage to save about $600 per month is a great way to increase your cash flow and gives you the option to pay down your mortgage or other debts, increase retirement savings, or save for a rainy day. But withdrawing from your retirement account may not be the best way to do that.
Early withdrawal penalties and taxes. Making early withdrawals from a qualified retirement account can subject you to early withdrawal penalties, in addition to any taxes you may owe on the income (earnings for Solo 401k plans and SEP IRAs are contributed before paying taxes, as are contributions for an employer sponsored 401k plan). Basically, you are looking at having to immediately pay taxes and penalties on your withdrawal. For example, you could expect to pay anywhere from 15-25% taxes on the withdrawal, plus 10% penalties, for a total withdrawal of 25-35% less than face value.
So instead of withdrawing $7,000, you would only get $4,550 – $5,250. You would lose several thousand dollars in the process. Instead of being able to use that money to finish the repairs on your house, the money would go straight to the government.
Regarding investment losses in a retirement plan. I wouldn’t worry much about being down $800 right now. The markets have been through a rough time in the last year or two, and almost everything is down (almost directly due to the state of the economy). Over time your investments should regain their value, and hopefully continue to grow as you get closer to retirement. Remember, retirement investing is a long term goal. With your retirement accounts you should be thinking in terms of when you can withdraw them without penalties – usually around age 59 1/2.
Should you cash out? Between penalties and taxes, you would only be able to complete less than half your renovation job (it requires $12,000 and you would only get $4,550 – $5,250 from your withdrawal). You would be giving up a huge percentage of your retirement investments and you are also setting yourself back further when it comes to retirement planning.
How will you make up the difference in your retirement accounts? Will you be able to contribute more toward retirement if you are able to refinance your mortgage? If not, you may be setting yourself back several years and need to work longer because you can’t afford to retire.
I can’t tell you which decision to make – but I hope this article helps you make a decision. Best of luck.
Comments
where i work they have terminated our retirement plan and we are allowed to get it out or rollover into something else. i am 43 years old and live in virginia and i would like to get part of mine out and roll part of it over into an ira. what penalties and taxes am i looking at having to pay when i take part of it out.
Janet, take a read through these articles: Should You Rollover a 401k into an IRA?, and What to Do With Your 401(k) When You Change Jobs (I know you aren’t changing jobs, but this article covers the options available to you).
As long as you roll your funds into another retirement plan such as a 401k, 403b, TSP, IRA, an annuity, or a similar retirement plan, then you will not have to pay any taxes or penalties. If you decide you want to cash a portion of it out, then you will have to pay the taxes on your withdrawal at your normal income tax rate, and you will have to pay an additional 10% tax on top of that. You will also owe state taxes for your withdrawal. In general, it’s not a god idea to make early withdrawals unless you absolutely need the money and there is no other way to get it.