Learn the options for making early withdrawals from your retirement accounts.
Money Girl
243 MG Should You Raid Your IRA or 401(k) Retirement Plan to Pay Off Debt?
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Leslie asks, "I have some high interest loans that I really want to pay off. My credit score isn't good, so refinancing them for a lower rate isn't possible. Can I withdraw money or take a loan from my 401(k) or Roth IRA to pay off my expensive debt? If you're like Leslie and are itching to rate your retirement account, you need to understand the rules. Different types of retirement accounts have different regulations for withdrawals that occur before you're officially retired. I'll tell you what you need to know so you don't make a major mistake and sacrifice your future. The rules for retirement accounts were designed to discourage you from dipping into them before retirement, or at least before you reach the official retirement age of 59 and a half. The government gives you money saving tax breaks to make retirement contributions, but they also charge you tax and penalties when you break the rules. That's why you should never put money in a retirement account that you might need early. Additionally, retirement accounts are not piggy banks that you can just crack open anytime you want some extra cash. You generally have to complete paperwork to document how you plan to use a withdrawal, and in some cases provide financial records to prove that you don't have enough money or assets to cover the expense on your own. Some retirement accounts have strict regulations that make it very difficult to get money out, even if you have a devastating financial hardship. If you take an early withdrawal from a traditional 401(k) or 403(b), the amount is subject to ordinary income tax plus an additional 10% penalty. There are only a few reasons the IRS even allows you to take a distribution from a workplace retirement plan, and I'll cover those in just a moment. Additionally, the retirement plan document that your employer created can further restrict what distributions are allowed. So always refer to your plan document or speak to your benefits administrator at work to fully understand your options. If it's permitted by your retirement plan, the IRS generally allows you to withdraw money from a 401(k) or 403(b) in the following six circumstances. Number one, to pay funeral expenses. Number two, to pay health insurance premiums if you become unemployed. Number three, to pay medical expenses. Number four, to pay higher education expenses. Number five, to buy or repair a principal residence. And six, to make mortgage payments that would prevent foreclosure of your principal residence. Although withdrawals for these six situations are allowed, they still incur a 10% penalty. There are several exceptions to the 10% penalty, including death, becoming disabled, or receiving a called active military duty. So, to answer Leslie's question, she cannot withdraw money from her 401(k) to pay off debt because that isn't a permitted withdrawal reason. However, if her retirement plan allows for loans, that could be an option. To find out more about the pros and cons of taking a loan from your workplace retirement account, be sure to listen to my previous podcast called Should You Take a 401(k) loan, which is episode number 191. Now, let's switch gears and talk about the rules for withdrawing money from a traditional IRA. Unlike your workplace 401(k), IRAs give you a little more flexibility because you control them, not an employer. However, loans are not permitted from any type of IRA-based retirement plan. You can withdraw money from them, but it's subject to the same consequences. Income tax plus a 10% penalty if you're younger than age 59 and a half. IRAs have the same exceptions to the 10% penalty as workplace plans, but they also waive the additional 10% tax for a few more reasons, like health insurance if you're unemployed, higher education expenses, and up to $10,000 to buy your first home. If you're like Leslie, you might be wondering if you should raid your Roth IRA. A Roth IRA gives you the most flexibility for taking withdrawals because the money you put in has already been taxed. Unlike a traditional IRA or 401(k) where you make pre-tax contributions, that means withdrawing contributions from a Roth IRA does not trigger income tax or a penalty. However, the earnings in your Roth are handled differently because they haven't been taxed. Withdrawing earnings results and having to pay income tax plus the 10% penalty. For example, let's say you made a one-time contribution of $5,000 to your Roth IRA. The account has now grown in value and is worth $6,000. You can withdraw $5,000 with no tax consequences, but tapping the earnings portion of $1,000 would generally trigger income tax plus the 10% penalty. That means Leslie could tap her Roth IRA to pay off her high interest debt. Now that you understand the options for raiding common types of retirement accounts, the real question is should you? Here are six reasons why raiding your retirement nest egg is a bad idea. ♪ You spend a over here ♪ Now at T-Mobile, get four 5G phones on us and four lines for $25 a line per month when you switch with eligible traders. All on America's largest 5G network. Minimum of four lines for $25 per line per month without a paid discount using debit or bank account, $5 more per line without auto pay plus taxes and fees and $10 device connection charge. Phones be at 24 monthly bill credits for well qualified customers, contact us before canceling entire accounts to continue bill credits or credit stop and balance on a required finance agreement too. Bill credits end if you pay off devices early. ctmobile.com. - I love learning and anything that makes learning easier. If you're a parent and your child needs some homework help, then IXL is a right for your family. 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Imagine earning a degree that prepares you with real skills for the real world. Capella University's programs teach skills relevant to your career so you can apply what you learn right away. Learn how Capella can make a difference in your life at Capella.edu. Okay, back to six reasons you should think twice before tapping your retirement funds. Number one, paying a 10% penalty takes a huge bite out of your account value. Number two, withdrawals that increase your taxable income can launch you into a higher tax bracket costing you even more. Number three, withdrawals can't just be paid back, you're subject to annual contribution limits. Number four, workplace plans generally forbid you to make new contributions for six months following a hardship withdrawal. Number five, you'd lose out on years or even decades of future account growth. And six, retirement accounts enjoy certain protections against creditors and in lawsuits. If Leslie wants to pay down her high interest debt, the best plan is to suspend making payments to her retirement accounts instead of rating them. By sending additional payments to debts, you can pay them off much faster without sacrificing your future financial security. Be sure to connect with me and get more tips on Facebook. Just log on to your account and do a search for Money Girl. You can also follow me on Twitter under username @lauraadams. You can also send your money questions to me at money@quickanddirtytips.com. If you forget any of this information, just visit the Money Girl page at quickanddirtytips.com where we post every show transcript plus additional resources. To find out more about smart ways to use retirement accounts, grab a copy of Money Girl's Smart Moves to Grow Rich. That's my award-winning book. It's available at your favorite bookstore in print or as an e-book. You can even read two chapters for free at smartmoves to growrich.com. 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