Tapping into 401(k)s early is tempting but perilous
Almost everyone with an Individual Retirement Account or 401(k)-style plan has felt the urge to tap into their money early. Many people have tens if not hundreds of thousands of dollars accumulated, and it can be tempting to access it, here and there.
About 1 in 5 loan-eligible 401(k) participants has a loan outstanding, reports the Employee Benefit Research Institute and Investment Company Institute. The average 401(k) balance, according to their research, was about $72,400 at the end of 2013, with the median around $18,400. The typical loan balance is around $7,000.
But whether it's smart to tap funds early is another matter. That depends on personal circumstances and potential drawbacks — namely, tax traps and the opportunity cost of diverting retirement assets for other uses. When it comes to accessing money before retirement age, there's a good, bad and ugly side to it.
The ugly
If you tap into IRA or 401(k)-style accounts early, with no intention or realistic means of paying the money back, there's a price to pay. The key one is a tax penalty of 10% when people make permanent withdrawals before age 591/2 (with some exceptions). Withdrawals also trigger regular income taxes.
Another disadvantage involves diverting funds from their intended purpose — retirement. It's not like most Americans are ahead of the game anyway. In a survey this year by the Employee Benefit Research Institute, 64% of workers admitted they are behind in saving for retirement. Pulling money prematurely from an IRA or 401(k) plan won't help.
The good
While premature withdrawals usually are a poor choice, you can tap some of the money to meet short-term needs. This can be a smart, or at least fairly neutral, decision — assuming you will return the money to the account reasonably quickly.
Many 401(k)-style plans allow participants to borrow a portion of the balances they have accumulated, usually up to $50,000. If you face a near-term cash crunch, a loan might be ideal in terms of speed and convenience, though you will be using after-tax dollars to pay it back.
The loan process is quick, often requiring little more than completion of an online form, with the money usually available within a few days. There's no credit application or need to qualify, no credit score to worry about and no impact on your credit history. The interest you pay goes back into your account, not to a lender, and rates typically are low — often 1 or 2 percentage points above prime. Balances are paid down through payroll deductions but can be paid off more quickly, if you want, without penalty.
The bad
One drawback to loans is that they divert money from your retirement account. "The main argument against borrowing from a 401(k) is lost investment return," wrote Jarrod Johnston and Ivan Roten, associate professors at Appalachian State University, in the Journal of Financial Planning in 2014. "The money borrowed is paid back with a fixed amount of interest rather than a potentially higher return from stock and bond investments."
Johnston and Roten argue against 401(k) loans, especially for people with the ability to borrow using a home-equity loan. The only times they consider 401(k) loans to be acceptable are under these three conditions:
•If the only other option is a loan carrying a high interest rate.
•If returns for the 401(k) investments are expected to be low.
•If the borrower has poor credit or faces a liquidity crunch.
Fidelity Investments found that people who take out 401(k) loans often mismanage their accounts in other ways. "Within five years of taking a loan, 40% of borrowers decrease their savings rate, and more than a third of those stop saving altogether," said Doug Fisher, a Fidelity senior vice president, in a statement.
The big danger comes if you can't repay the loan. In that case, it becomes a withdrawal on which taxes and the 10% penalty could apply. Leaving your job, including being laid off, also would trigger the need to repay a loan, within two or three months.
IRA wrinkles
Tapping money from IRAs is different from 401(k) plans. You can't borrow against a traditional IRA, but you have 60 days to roll over funds between financial companies serving as custodians. This lets you gain access to the money in the interim —an informal short-term loan. A new wrinkle limits investors to just one rollover every 12 months, regardless of the number of IRAs owned.
It's important to complete a rollover within 60 days. Otherwise, the transaction becomes a withdrawal, with proceeds subject to ordinary taxes and the 10% penalty.
IRA withdrawals might or might not be taxable, depending on the account and situation. Regular taxes usually apply, but there are exceptions to the 10% penalty on withdrawals taken before 591/2. These include college costs, disability, large medical expenses and first-time home purchases. On Roth accounts, the amount representing contributions can be withdrawn at any time, free of taxes and penalties, but regular taxes and the penalty might apply on investment earnings.
Even if you avoid a tax bite when tapping retirement money prematurely, it's not necessarily a smart move. It removes money from a tax-sheltered umbrella and reduces your retirement assets. If your main goal is to build up a nest egg, that could be a step backward.
Reach the reporter at russ.wiles@arizonarepublic.com or 602-444-8616.