The New Retirement Threat
|July 28, 2008||Posted by Roshawn Watson under Uncategorized||
By: Roshawn Watson
However, anytime you spend tomorrow’s money today, there are consequences. The primary concerns are taxes, fees, and substantially diminished returns.
Most 401K plans allow people to access their funds two ways: 401K loans and hardship withdrawals.
One may borrow as much as 50% of their vested balance or $50,000, whichever is less. Repayment periods can also vary. For example, many loans must be repaid within 5 years whereas a loan for a mortgage can generally be repaid over 15 years. If these loans are not repaid, one must pay their ordinary income tax and a 10% penalty-fee for early withdrawal. Note that up to one-third of these loans are not repaid.
Alternatively, hardship withdrawals from 401K differ in that they cannot be repaid and can only be taken out under specific circumstances (i.e. avoiding foreclosure, eviction, bankruptcy, etc). Since these withdrawals are not repaid, like many 401K loans, they are subject to ordinary income tax and trigger a 10% penalty-fee for early withdrawal. Additionally, one must stop contributing to their 401(k) for at least six months after taking a hardship withdrawal.
According to the Vanguard Group, these hardship withdrawals were up by 8.6% last year compared to 2006.
Also, one can withdraw $10,000 from an IRA without penalty for qualified first-home expenses or for qualified higher-education expenses.
Still, one is subject to ordinary income taxes and will have diminished earnings on the IRA as a result of the withdrawal. These retirement savings losses are very substantial. Consider someone taking out $10,000. If one achieved an 9% average growth rate over 20 years, he or she would have had $60,092 if they had not taken the withdrawal. Ouch!
Repaying these loans and withdrawals also brings some additional financial considerations. Take 401K loans for instance. Even if these loans are repaid on time, they are paid with after-tax dollars. These borrowers will have to pay taxes a second time when the money is accessed for retirement. For IRAs, the biggest concern may not be one’s ability to pay back the withdrawal but rather the contribution limit per year. One can only contribute $5,000-6000 per year depending on his or her age. This means one often cannot compensate for a big withdrawal by contributing more the next year.
In general, the only time to tap a retirement account is in dire circumstances (to avoid bankruptcy or foreclosure). It is much better to temporarily stop retirement contribution and cut expenses to address an impending financial challenge before touching retirement funds.
Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.