If you’re like me, you’ve seen movies, and if you’ve seen as many movies as I have, you’ll have seen the movie trope where a family falls on hard times, then in a moment of desperation, the parent says, “I can just borrow the money from my 401K/retirement account”. Is it just be that has seen that in a handful of movies? Regardless, that scenario actually happens in real life, and there are real life consequences to go along with borrowing from your retirement account, and a lot of people don’t know that until it’s too late.
Income tax consequences
When you take a distribution from your retirement account before retirement age, you will have to pay upfront income taxes. The rules for an early withdrawal from your Roth IRA are a little different though. If you’re making a withdrawal before retirement age on a Roth account, you won’t be facing income taxes, because that’s the principal of a Roth account, but you could be taxes on investment earnings that your account earns.
Best advice to go with is to check with your account administrator before any withdrawals.
Penalties and fees
Whether you have a 401K, or IRA, all retirement accounts are subject to a 10% penalty on top of your income taxes that you just incurred. Depending on the amount in your account, the penalties could amount in the $1000’s. There are, however, a few exceptions to the tax penalty, including unreimbursed medical expenses, or permanent disability of the account owner. A complete list of penalty exceptions acceptable by the IRS can be found here.
In the end, early withdrawal might not be an option
Banking on your retirement account as an emergency fund can be trouble not only for the reasons above, but also because you may not even be able to withdraw anything before you hit retirement age. Each employer or account administrator sets their owns rules to determine whether or not employees can even withdraw early if it’s not for medical expenses.
You’ll be missing on potential growth
It’s simple math that if you start contributing to your account at a young age like 25, that by the time you’re ready to retire, your account has exponentially grown in comparison to someone that started their account ten years after you at 35. That’s compound interest at work. When you take money away from your account at any age below retirement, it’s assumed that that money won’t be earned back for a number of years, because taking an early withdrawal not only temporarily halts regular contributions, but also permanently reduces your account balance, thus setting back the compounding process.