As we write this from our new headquarters in Denver, Colorado, we’re expecting 3 inches of snow, on the 18th of May. It’s supposed to be springtime, and for the most part, it is – flowers have bloomed, trees are full of leaves, the grass is green, but in the middle of what should be warm, sunny, gorgeous spring days, here comes a surprise snowstorm. Forecasters are telling us to drag our flowerpots inside and cover newly budded greenery outside, and to expect snapped tree branches (because branches full of leaves hold a LOT more snow than dormant ones). In the middle of our “bright and sunny”, bird-chirping days, winter wants one last lash.

That analogy works well in the case in our financial lives, too: in what is supposed to be a long season of growth in our careers and finances, there are those unexpected storms that blow in and lay waste to our financial flower garden. This is one of the reasons we buy insurance – to protect against an unexpected, potentially catastrophic loss, and it’s the reason every good financial advisor will stress over and over again the need to have established an emergency fund. You simply need to expect the unexpected: you can’t know exactly what unpleasant surprises loom in your family’s future, but be assured, there will be some.

So what happens when you don’t have adequate preparation in place, and something bad happens? Job losses, divorces, illness or injuries, or something like a hurricane or tornado can wreak havoc on a family’s finances in a moment. Where do you go when you have a sudden need for cash? For many people, the only place they CAN go, is money that was set aside for much later in life: your retirement savings.

One of the cardinal rules at nVest Advisors is: “Thou shalt not touch thy retirement money”, but for most of us, our retirement accounts are our largest source of available money (or what we think is available money) when urgent needs arise. 

If you are working with a financial planner or advisor, we hope you’ve got an emergency fund set up and you continue to grow it at every opportunity. But if you don’t, and you’re faced with serious financial hardship, the balance in your 401k or IRA might be overwhelmingly tempting. And in some extreme circumstances, tapping your retirement funds may be your last refuge.

The problem is, those accounts were given special tax treatment by the IRS because they are supposed to be used later for retirement. And the more we fund our own retirement, the lighter burden we will be on Social Security and Medicare in the future. So we are given incentives, like possible tax deductions when we put money in, and tax-deferred growth for as long as it remains in the account, but we are also given a “slap on the wrist” if we take it out early. And sometimes, that slap can be really painful.

If you’re faced with the dilemma of an urgent financial need, and are considering taking funds from a retirement account, ask yourself the following:

First, is it accessible?

Although you can take funds out of an IRA or ROTH IRA at any time for any reason (because they are personally owned by you), employer-sponsored plans come with more more restrictive rules. Plans like a 401(k), 403(b), and 457 have special contribution and withdrawal rules designated by the IRS, and are much more difficult to get money out of. What the IRS has created is a list of about a half-dozen reasons you can request an early withdrawal, and not every employer plan will honor all of them.

Early withdrawal reasons (sometimes called “triggering events”) include:

  • The employee reaches retirement age as defined under the plan.
  • The employee becomes disabled.
  • The employee dies, at which time the beneficiary is eligible for distributions.
  • The employee separates from service.
  • The plan is terminated and is not replaced by another defined contribution plan.

Some plans also permit in-service withdrawals for financial hardship, first-time home-buyers, or unforeseen medical expenses, but each plan will differ. Check with your payroll or benefits office for more information.

Hardship withdrawals will often require proof of financial hardship, such as overdue bills.

Second, what costs are involved?

Here’s where it gets tricky. For most withdrawals from retirement accounts before age 59 1/2, your distribution will be taxed at your regular income tax rate PLUS a 10% early withdrawal tax penalty.

There are two exceptions to mention quickly:

  1. ROTH IRA contributions are not deductible when you make them (because ROTH IRAs are generally tax-free in retirement), so only the growth of your account is taxable, not the amount you put in. Also, ROTH IRAs are taxed as “first-in, first-out”, meaning all of your contributions can be withdrawn first (without tax or penalty), and then the taxable earnings are taken out.  (This makes the ROTH IRA a great investment vehicle for many other reasons than just retirement savings, and at nVest Advisors, we like and use ROTH IRAs in a variety of ways to serve a family’s financial goals).
  2. The IRS allows for a few generally administrative reasons for withdrawals from a retirement account without paying the 10% penalty (such as finding out you contributed too much in a year, and pulling the excess back out before year-end). Also, beneficiaries can withdraw after the death of the account owner without the additional penalty.

It’s important to remember that whatever amount you take out of your retirement account will be added to your total taxable income for the year. This can dramatically raise your income for the year, potentially pushing you into a higher tax bracket as a result. This is why it’s vitally important that you consult with your tax preparer BEFORE taking money out of a retirement account.

Next, is there any alternative?

For individually-owned retirement accounts, like an IRA or ROTH IRA, the rules are so relaxed about withdrawals that the IRS doesn’t allow for any alternatives to a withdrawal.

Retirement Plan Loans

But for employer-sponsored plans, that have much more restrictive withdrawal rules, the IRS does permit the plan and it’s investment providers to allow for loans against the balance of your account, and taking a loan may be the far better option than paying all of that extra tax and penalty on a full withdrawal.

A loan on your employer-sponsored account is pretty straight-forward.

First, there must be at least $2,000 in the account before a loan is permitted, and the amount available to borrow is nearly always 50% of the account balance.

You will never need to quality for the loan (with things like income or credit), because the loan is secured against the balance in your account.

Rates are typically lower than other kinds of emergency lending, such as a bank signature loan or a credit card, and repayment terms are generally 5 years (up to 15 if you borrow to buy a home). And as long as you make the payments as scheduled and never default, the money you borrowed was not taxable.

If you do default, however, and fail to catch the payments up by the close of the plan’s year, the plan is required to report that defaulted loan to the IRS as a withdrawal, and the unpaid balance will be subject to income tax and the 10% penalty.

Withdrawal of cash value from life insurance

If you have a personal, permanent life insurance policy that grows a cash value (it’ll be a name like Whole Life, Universal Life, Variable Life, or some version of those), a portion of the cash value of the policy can be withdrawn with less tax due than a 401k or IRA withdrawal. Like a ROTH IRA, cash values from life insurance are taxed on a “first in, first out” basis, so you can withdraw up to your total premium amount from the cash value without additional taxes due.

But please take note: this strategy is fraught with risk. 

Many life insurance policies deduct your insurance costs from the cash value each year, and so a withdrawal of too much may make your policy lapse prematurely without substantially more premium payments from you later on. Also, causing your policy to lapse by cashing out your life insurance will mean that you must again prove you are healthy enough to be covered. It will also subject you to a new period of contestability, meaning that the insurance company can reject a life insurance claim in the first two years based on their look at your medical history. You’ll also be older, so a new policy may cost substantially more than the one you just terminated.

Before taking this step, please check with your insurance agent and tax preparer and make sure you understand the risks.

Hold a garage or yard sale

This may sound crazy, but in some cases, when the financial burden is fairly small (say, a few thousand dollars), simply emptying your home of unneeded items or holding a bake sale make actually solve your problem without touching your retirement savings or paying a bunch in taxes.

If it’s not immediate, consider a part-time job for a short period of time.

This one is self-explanatory, but if your need isn’t immediate and urgent, consider working a few hours a week in a part-time job to cover the expense instead of cutting into your retirement savings. (You might also consider staying on at that part-time job until your emergency fund is fully funded, too.)

If you absolutely have to…

If, in the end, you finally do need to withdraw from a retirement account, here are the things we advise our clients to keep in mind and take to heart:

  1. Take withdrawals in small, frequent amounts. It’s better to withdraw small and often than to withdraw a large sum you later find out you didn’t need.  Once it’s out, it can take years to put back in.
  2. Remember, only the funds you are fully vested in (funds that are now fully yours) are eligible. Your employer’s matching or profit-share contributions may not be eligible.
  3. Set a goal for yourself not to ever need to do this again. Whether that means working a part-time job, or cutting living expenses, commit that once you’re out of this situation, you MUST build an emergency fund. No ifs, ands, or buts.
  4. Commit to a period of time to get the money you took out back in. Treat your withdrawal as a loan, and give yourself a set period of time – 5 years or less – to put the funds back in. You need to do this IN ADDITION to the contributions you were making before.

If you’re not sure what to do:

We’d love to help. Give us a call at 888-852-0702 to speak with a financial advisor free-of-charge and without obligation, or schedule a free consultation appointment online today.