After a lot of scrimping and saving, you’ve finally started building up some retirement savings in the form of a 401(k) or IRA. If you’re lucky, you may even have an emergency fund set aside in a savings account.
But your financial situation could quickly change, whether as a result of a layoff, a medical emergency, or a spouse’s drop in income. While it can be tempting to tap into your retirement account in order to keep up with payments or avoid losing your home, this is a bad idea.
Why should you avoid withdrawing funds from your retirement account?
For both federal and state income tax purposes, all of the money you withdraw from your retirement account is taxable. If you’re under age 59 1/2, you also face early withdrawal penalties: 10 percent from the IRS, plus whatever your state charges.
Additionally, the plan administrator is required to withhold 20 percent of your distribution to pay the IRS. You still pay taxes on that money, even though you never receive it, and this 20 percent is generally not enough to cover your IRS taxes in full. The 20 percent also doesn’t cover your state taxes—for which you’ll still be responsible—and when April 15 rolls around, you will have to come up with more money to pay the tax balance due on these funds.
While there are special exclusions for certain uses of funds when you’re unemployed, they only apply to funds drawn from an IRA and not a 401(k), 403(b), or other pension account. To get the exclusion, you must first move the money from your retirement account into an IRA and then draw the money from the IRA. After all of that, the only benefit you receive is that you avoid the early withdrawal penalty. You must still pay the taxes on the funds drawn.
By the time you take into account all the taxes and penalties due on the cash you actually receive, after withholding, your effective cost for using that money is often well over 50 percent.
What’s worse is that using those funds now will leave you nothing for retirement. Sure, may you desperately need the money now, but if you spend it you’ll never save it up again. There is likely a better way.
What are your alternatives?
Look for a cheaper source of funds. If you haven’t waited until you’ve defaulted on key debt, you can use your credit. You may want to find out if you can get a home equity line of credit (Incidentally, it’s a good idea to have one of those handy while times are good. It’s easy to tap into when there’s an emergency.) or use your credit cards, as their interest rate is generally lower than 50 percent.
Whatever line of credit you choose, use it for a year or two. Also ask your friends, family, and banker for help. If you have always been a responsible person, someone may trust you enough to help you out, as long as you are taking other positive steps to help yourself.
I think the best alternative is this: start a business. Look around for something the community needs, and set yourself up to provide it. With a business in place, you can set up a solo-401(k), into which you can roll your existing retirement funds.
If you’re married and your spouse is in business with you, you can also roll your spouse’s funds into his or her own solo-401(k). Each of you can now borrow up to 50 percent of the funds in those 401(k)s, up to $50,000 from your respective accounts, tax-free. You will be paying yourself back over a specific number of years, so you will replenish that account. And because you’re really running a business, you’ll be back on your feet in no time!
Eva Rosenberg, EA is the publisher of TaxMama.com ®, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.