Your retirement savings are intended (obviously) for retirement, but what if you need them now? The IRS offers some provisions for withdrawing savings from an IRA or 401(k) before retirement age without incurring a penalty—and President Barack Obama recently added another hardship option in his budget proposal. But that doesn't mean it's a wise move.
A new white paper from the Center for Retirement Research at Boston College estimates that about 1.5 percent of assets "leak" out of 401(k)s and IRAs each year, on average, through early withdrawals, cash-outs or loans. Many are the result of a job loss or job change (an estimated 3 in 10 who leave their jobs cash out their accounts, according to Vanguard data) or an unexpected health-care expense. But while tapping into retirement savings can provide temporary financial relief, the long-term effects can be costly.
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The center estimates that aggregate 401(k) and IRA retirement wealth is at least 20 percent lower than it would have been without such leaks. And the effects on an individual's savings can be even greater, depending on how much has been withdrawn and when, or whether, it's replaced.
"Generally, it's considered not a good idea to pull money out of 401(k)s or retirement accounts [early]," said Ben Barzideh, wealth advisor at Piershale Financial Group in Crystal Lake, Illinois. "With any money you pull out, you are also giving up the opportunity cost of what that money would have grown to if you had just left it alone. Certainly, though, sometimes life throws something unexpected at us and we may be in a tight spot."
Here are four common reasons for taking early withdrawals—and what the experts have to say about each.
When you experience a job loss or an emergency need for cash, it can be tempting to withdraw funds from a retirement account. And there may soon be an opportunity for those who've been unemployed for awhile to do so without a penalty.
President Obama's proposed budget, released earlier this month, includes a hardship exception to the typical 10 percent penalty for early withdrawals for those who've received unemployment for more than 26 weeks, allowing them to take out up to $50,000 per year from IRAs and employer-sponsored plans.
There are other hardship provisions in existence as well. If you retire, quit or get fired at age 55 or later, for example, you can take money out of your 401(k) without paying the usual 10 percent penalty. Some 401(k) plans will also allow you to borrow from your 401(k) and pay it back over five years.
And with a Roth IRA, you can withdraw your contributions (but not earnings) at any time without paying a penalty. Still, advisors caution against doing so except as a last resort.
"Taking distributions before you are ready to retire should be avoided," said Peter Huminski, president and wealth advisor at Thorium Wealth Management in Kernersville, North Carolina. "But some people are faced with exceptionally dire financial situations ... and in those instances it may be OK to dip into retirement accounts to cover the shortfall. It should be the last place you go, though, when all other options are exhausted."
If your financial need is medical, you may also be able to withdraw retirement funds without penalty. For instance, if you are unemployed, you may take penalty-free distributions from an IRA to pay for your medical insurance if you meet eligibility requirements, Barzideh said. Some medical expenses that are not reimbursed are also penalty-free. If you become permanently and totally disabled, you can also withdraw from your retirement accounts without penalty.
However, even in these instances, retirement experts advise against withdrawals except as a last resort. "Certainly if you had some medical issues and have no other way of getting money, then it may be necessary to use some of the money from your retirement plan or 401(k) to pay for those costs," Barzideh said. But only as a last resort.
The IRS allows you to withdraw up to $10,000 from an IRA without penalty for the purchase of a first-time home or if you haven't owned a home in the past two years. Many experts see this as the only justifiable reason to withdraw funds from a retirement account. "A home is not only an investment, but it's something that brings people happiness," Barzideh said. "You are not using that money to buy a depreciating asset like a car or taking a vacation; instead, you're using it for something that is an investment and usually will grow over time."
Usually is the operative word, though. As the housing crisis illustrated, home prices can fall as well. So think carefully before tapping your retirement account to buy a home.
While higher education expenses can be withdrawn from an IRA penalty-free, the same is not true for 401(k)s. Those college expenses can be for yourself, your spouse or a child. Still, even if the withdrawals are without penalties, they may not be worth the long-term costs, say advisors.
"Your children can work and take out loans to pay for their own college. You can't take a loan out to pay for your retirement if you haven't saved enough," said Barzideh. "You never want to sacrifice your own retirement to pay for your children's education."
While early withdrawals from your retirement savings may be unavoidable at times, it's important to carefully weigh the opportunity costs. For instance, if a 30-year-old withdraws $10,000 from her retirement account, assuming an average annual growth of 8 percent, that $10,000 would have grown to $147,853 by the time she reached age 65, Barzideh said.
"When you take a withdrawal, you are losing the ability for those funds to potentially grow," Huminski said. "The journey to retirement requires patience, discipline to contribute regularly and time. If you take funds out of your retirement accounts as you go, you lessen the likelihood of reaching your income goals in retirement."