Your Company’s Retirement Plan May Allow Early Withdrawals
It may be comforting to know that your retirement plan money can be withdrawn early if needed.
Are you hesitating to invest in an employer-sponsored retirement plan because you want access to your money if you need it? While retirement plan savings should be preserved for retirement, you might be able to take out your money early for other needs. If your plan allows loans or hardship withdrawals, it’s important to know you can use your savings in an emergency.
If you take a loan from your retirement plan, you’ll withdraw money from your account to use now. You’ll then pay back the loan in installments. A portion of the loan amount will be automatically deducted from each paycheck and put back into your account.
You’ll have to pay interest on the loan, but that’s not as bad as it sounds. The interest actually goes back into your account. In other words, you’re paying the interest to yourself.
- Your plan may not allow loans, so check with your employer.
- Loan amounts are limited to half of your vested account balance, up to $50,000.
- Plans may have a minimum loan amount (often $1,000).
- The interest rate is usually 1% to 2% above the prime rate, which is the interest rate banks charge their best customers.
- Generally, loans must be paid back within 5 years. Home purchase loans may be extended longer.
- Some plans might only allow loans for specific uses, such as education expenses, housing costs, medical expenses, or the purchase of a first home.
- You can pay off a loan early.
- Plans may limit the number of outstanding loans you can have at one time.
- You may have to pay loan initiation and maintenance expenses.
- Access to your savings. You can get money to pay for current expenses.
- Easy and convenient. There’s no credit check and little paperwork.
- Receive the full amount. The loan is not subject to income tax or penalties, as long as loan rules are met.
- Low interest rate. Banks and credit cards may charge you more. In addition, you pay the interest to yourself.
- Potentially less money at retirement. Unless you save more to catch up, taking a loan could leave you with less at retirement. You won’t earn as much on the loan amount if the interest rate on the loan is lower than what your money would have earned in your account. Also, you may be inclined to reduce your contributions while paying back your loan. See the example illustrating the long-term cost of a loan below.
- Defaulting on a loan can be expensive. If you leave your employer, you may have to pay off your outstanding loans immediately to avoid income taxes and early withdrawal penalties. Any amount you don’t pay back will be treated as income by the IRS and will be subject to taxes and penalties.
Take a Hardship Withdrawal
Your plan may allow you to take hardship withdrawals for large and immediate financial needs, such as expenses for education, housing, medical care, or funerals.
The short-term cost of a hardship withdrawal is that you’ll pay applicable income taxes and early withdrawal penalties. For example, if you needed $10,000 and opted to have taxes of 25% withheld, you’d need to withdraw $13,333. You might also have to pay an additional 10% for an early withdrawal penalty at tax time.
The long-term cost of a hardship withdrawal could be even greater. Unlike loans, hardship withdrawals cannot be paid back. The money withdrawn leaves your account and loses its tax-advantaged growth potential. A withdrawal could leave you with significantly less at retirement unless you increase your contributions. Even then, it may be difficult to make up for lost time and the benefit of compounding. The rules also prevent you from contributing to your plan for six months after a withdrawal.
Consider Other Alternatives
Taking a loan or hardship withdrawal from your retirement plan account to meet short-term needs can end up costing you more than you expected in the long run. That’s why you may want to use your retirement account only as a last resort.
Ask your human resources department whether the plan allows you to tap into your savings early.
Your financial professional can help you explore all of your options. Together, you’ll be able to make informed decisions.
The Long-Term Cost of Borrowing
Mary plans to retire in 30 years and has $50,000 in her retirement account. She contributes $200 a month.
Mary takes a $10,000 loan and pays 6% annual interest. Her monthly loan payment is $193.33 over 5 years. To keep her take-home pay about the same, Mary stops making contributions while repaying the loan. She starts contributing again after the loan is repaid.
How much would this $10,000 loan cost in the long run? Compare Mary’s account value at retirement with and without the loan:
Took a loan:
Didn’t take a loan:
A $10,000 loan would leave Mary with about $113,000 less in her retirement account after 30 years if her contribution level and investment returns remain unchanged.