No matter how hard we try to avoid unexpected costs, it often seems as though they are hiding behind every corner. Whether it’s the middle of the summer and your HVAC goes out or your roof caves in after 12 years of wear and tear, unexpected costs are bound to happen. To afford these emergency expenses, some may consider taking an early retirement withdrawal. But, while this may seem like the perfect solution for your costly problem, there are a few things you should consider before taking funds from your retirement account before you retire.
With this in mind, here are six questions you should ask yourself before using your retirement savings to afford emergency expenses.
Do I need this money?
Although it’s essential to have a new HVAC system, other expenses may not be as urgent. For example, if you are considering an early retirement withdrawal to pay for other unforeseen expenses such as a new kitchen renovation or to pay for your daughter’s extravagant wedding, you may want to decipher if you need the funds.
Since the goal of a retirement savings account is to put money away for your golden years, it’s not wise to rob yourself of your future nest egg. By taking money now, you’re reducing the amount of money you’ll have for your future. Additionally, the money you take out won’t grow any interest. This means you’re cutting into your retirement funds.
When you’re on a fixed income in retirement, you will miss the money you used during your working years. So, if the expenses aren’t an absolute emergency, then you may want to consider holding off for the time being.
Do I have another source of cash to use as an alternative?
You want your retirement savings to be as plentiful as possible when you leave the workforce so that you can retire comfortably. So, it’s wise to see if you have any other cash reserves you can use as an alternative money source. For example, do you have some money in savings or maybe an emergency fund? If so, you want to tap into those savings accounts before you tap into your retirement savings.
How old are you?
If you plan to take money from your 401(k) or IRA accounts, you must be 59 ½ to take a penalty-free distribution. However, even if you’re 59 ½, you will still have to pay taxes on your traditional IRA or 401(k) distribution amount. If you choose to take money from your Roth account, you won’t have to pay taxes or a penalty on your distribution as long as you have had it for five years.
If you’re under 59 1/2, you’ll be hit with a 10% penalty in addition to any taxes you owe. There are exceptions if your distribution is for a certain reason such as qualifying education expenses.
For example, let’s say you’re under 59 ½, need a $3,000 distribution, and fall into the 22% federal tax bracket and 5% state tax bracket. You’ll end up owing:
- $300 in an early withdrawal penalty
- $600 in federal tax withholding and $180 in state taxes
- And $150 in addition to taxes
In total, you will pay $1,230 and receive a distribution of $1,770. Essentially, you’re paying 41% in taxes. With this in mind, it’s wise to wait until you reach 59 ½ to take an early withdrawal from a retirement account.
Is it a qualifying distribution?
There are a few instances where you may not have to pay the early withdrawal 10% penalty. The following situations may include:
- Again, you’re over 59½
- You have become totally and permanently disabled
- You’re the beneficiary of an IRA owner who has died
- The distribution is to buy, build, or rebuild a first home.
- You’re receiving distributions in the form of an annuity
- You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income for the year
- You’re paying medical insurance premiums during a period of unemployment
- The distributions qualify for higher education expenses
- The distribution is due to an IRS levy of the qualified plan
- Your withdrawal is a qualified reservist distribution
- You may also qualify for disaster relief
While you won’t have to pay a 10% distribution penalty, you may still have to pay income taxes on your withdrawal. When deciding if you need to take an early distribution, make sure to consider the additional taxation.
Are there any financial consequences for taking a retirement withdraw?
The biggest drawback when taking an early retirement withdrawal is that you’re taking from your retirement. While everyone requires a different savings amount, it’s important to accumulate as much as you can during your working years. Even though the tax consequences of an early withdrawal are short-term, the financial impact a withdrawal may have long-term is more detrimental.
If we continue to use the $3,000 withdrawal example from above and assume your retirement savings receive a 7% interest rate, the potential future value of your $3,000 today could be $11,609 by the time you retire in 20 years.
Should I speak with my financial planner first?
If you’re still unsure after you ask yourself all of the questions above, it’s wise to consult with a financial planner. Your financial planner can help you better understand your options. Have you ever heard the saying, “Sometimes you can’t see the forest through the trees”? When it comes to making financial decisions, it may be challenging to see the entire picture because you’re too close to the problem. If you’re too close to the problem, you may struggle to weigh out the pros and cons.
Financial planners are great resources for helping you evaluate your options. They can show you each path and how it will impact your financial future. Combining a financial planner’s knowledge and experience with your passion for achieving your goals will help you make the best decision. You don’t want to make a financial decision that will end in financial distress.
The bottom line
If you take an early retirement withdrawal, you are taking away from the money you will have to live off when you are no longer working. While some circumstances might require you to borrow from your future, you should be judicious about using your retirement fund to pay for anything before you start taking your retirement distributions.
If you find yourself having to make a hard decision about whether to take an early withdrawal from your retirement fund, you may want to speak with a financial planner. Our team of retirement planners can help you make the best decision for you, your family, and your future.