FA Playbook

The cost of tapping your retirement accounts early

Eric C. Jansen, president and CIO of AspenCross Wealth Management
Key Points
  • Tapping retirement account balances before age 59½ can result in tax obligations and penalties.
  • Some early withdrawals are exempt from penalties, but taxes will be due on funds saved on a pretax basis.
  • Roth IRA contributions, made on an after-tax basis, are a possible source of early withdrawal funds.
Thierry Dosogne | Getty Images

When money is tight and times are tough, it can be difficult for retirement savers to ignore the money they've stashed in a 401(k) plan, IRA or other retirement savings account. Still, while it may make sense in some situations to tap into those accounts early — for example, if a job loss has put you at risk of losing your home — it should always be the very last resort.

Here's why: Not only will you pay significant taxes and penalties for an early withdrawal, you'll also reduce the amount of savings in your account that are available to enjoy market gains. And those market gains may make the difference between a successful, leisurely retirement and one that's a struggle.

Taxes and penalties

First, let's consider those taxes and penalties. Let's say you're not yet 59½ (that's the age at which the early withdrawal penalty no longer applies) and you withdraw $20,000 from your 401(k) plan. Let's assume you have a 25 percent effective income-tax rate, including state taxes, and add the 10 percent penalty for early withdrawal (this is assuming you don't qualify for an exemption, some of which are detailed below). That $20,000 is now just $13,000.

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In addition to taxes and penalties, don't forget the lost investment gains. Consider a 30-year-old worker who, rather than withdrawing $14,000 out of his retirement account instead leaves that money in his 401(k) plan to grow. Even if he never contributes another penny, that $14,000 would grow to $152,147 by age 62, assuming an 8 percent average annual return. Of course, that's not going to happen if the worker withdraws that $14,000 at age 30.

Early withdrawal exceptions

Still, there are situations in which one can pull money out early from a retirement account without triggering the 10 percent penalty, though you can't avoid paying income taxes on the money. Note that the rules for these exceptions vary, depending on whether you have an IRA, 401(k) or other type of retirement plan. For example, you can avoid the 10 percent penalty on early withdrawals from both IRAs and 401(k)s if you use the money to pay medical expenses that top 10 percent of your adjusted gross income.

But while early IRA withdrawals are exempted from the penalty if the money is used to pay health insurance premiums while you're unemployed, that particular exemption is not available to 401(k) plans. Similarly, while an early IRA withdrawal to pay for qualified higher-education expenses or to pay up to $10,000 for the purchase of your first home won't be subject to the penalty, an early withdrawal from a 401(k) for the same purposes affords no such relief.

Meanwhile, people who institute a process of withdrawing a series of "substantially equal payments" over time from either account type, under a provision known as the 72(t) rule, can avoid the early withdrawal penalty.

It's important to note that if your employer offers hardship withdrawals from the company 401(k) plan, and if you qualify for such a withdrawal, you'll still owe the 10 percent penalty (assuming you're under age 59½) plus income taxes on that money.

While it may make sense in some situations to tap into those accounts early — for example, if a job loss has put you at risk of losing your home — it should always be the very last resort.

Another way to pull money early from a 401(k) is by taking a loan, assuming your plan allows them. To avoid the penalty and taxes, you're required to pay the loan back, with interest. A word of warning: If you happen to lose that job while you have a loan outstanding, you're required to pay back the balance in short order or risk getting hit with the penalty and taxes on the amount that you haven't paid back.

Roth IRAs

Meanwhile, Roth IRAs offer a somewhat different approach, because the money you're putting into the account is after-tax rather than pretax. Thus, once you own the account for five years, there is no limit or penalty on the withdrawal of the contributions you've put into the plan (though withdrawing any investment earnings does trigger tax consequences), because you've already paid taxes on that money.

That makes Roth IRAs to some degree more flexible in terms of pulling money out before you're ready to retire. In fact, some finance experts suggest using a Roth IRA as a place to stash longer-term emergency savings. That said, others argue that the best use of such accounts is what they were designed for: saving for retirement. As with all things retirement, it makes sense to discuss the ins and outs of various account types with a professional financial planner.

(Editor's Note: This column previously appeared on Investopedia.com.)

— By Eric C. Jansen, founder, president and chief investment officer of AspenCross Wealth Management