For anyone in need of funds—for college, a housing down payment, credit card debt relief—a retirement nest egg can be incredibly tempting. However, consumers should think twice before tapping their 401(k)s and IRAs.
Retirement plan loans and withdrawals almost always come with penalties and fees that can make them costlier options when compared with other funding choices. What’s more, taking money out of a retirement account reduces the retirement nest egg as well as its interest-earning power, possibly resulting in a less secure retirement down the road.
Here’s a look at the benefits and drawbacks of the various retirement plan loans and withdrawals consumers can choose from:
- 401(k) loans: Loans taken from a 401(k) have low interest rates and are available regardless of credit score. One key benefit: the interest paid on a 401(k) loan “goes back” to the retirement account instead of, say, a lender, so recipients are essentially paying their future selves.
However, 401(k) loans must be repaid within five years, which is a relatively short timeframe compared to the lifespan of other loan products. Additionally, if you leave your job for any reason—whether by choice or through a layoff—the loan must be paid back quickly: within 60 days. If you don’t make the deadline and you’re under 59.5 years old, you’ll owe a 10 percent early withdrawal penalty on the outstanding loan amount as well as federal and state income tax on the distribution.
- 401(k) withdrawals: Many plans—but not all—allow withdrawals for financial “hardships,” which can include expenses like college tuition, a first-time home purchase or medical bills. However, you’ll pay a 10 percent early withdrawal penalty as well as federal and state income tax if you’re younger than 59.5 years old. (One caveat: Some plans allow for penalty-free withdrawals in light of certain circumstances, such as a disability or high medical bills.)
The biggest drawback of taking an early 401(k) withdrawal, however, is that the money doesn’t have to be repaid. Borrowers miss out on the interest and earnings those funds could have produced and must save more over the long run.
- IRA withdrawals: IRA loans aren’t possible, but early withdrawals are allowed, often with less restrictive terms than those of 401(k) withdrawals. Borrowers can avoid the 10 percent penalty if the funds are used for a first-time home purchase or using education. The penalty is also waived if the money is borrowed and paid back within 60 days, though borrowers are only allowed to use this option once a year.
However, again, money that’s withdrawn from a IRA doesn’t have to be repaid, which can dramatically reduce the amount of money that will be available at retirement.
For anyone interested in tapping retirement savings now, there may be a significant price to pay later. Consumers should consider all of their options and their respective benefits and drawbacks before dipping into their nest eggs.