Withdrawing funds early from a 401k or IRA often seems like a tempting option to cover life’s immediate expenses, but it should generally be avoided. Think of these accounts as a wound that heals only if left undisturbed; withdrawing funds is like picking at a scab, slowing down the healing process and potentially leading to financial “amputation” or a ruined retirement.
The best approach is to treat your retirement accounts as a one-way street—money goes in and stays there until you retire. For everyday financial needs, focus on building robust after-tax investment accounts instead.
However, life can throw curveballs, and if you’re in a dire situation where your retirement funds are your only option, then you may need to make a withdrawal. It’s important to remember the missed opportunities for growth, though. For example, in 2020, the S&P 500 grew by 18%, and the NASDAQ by 43%. Withdrawing that year would have meant missing out on these gains.
Changes to Withdrawal Rules
The CARES Act of 2020 temporarily adjusted the rules for early withdrawals due to the pandemic. Normally, pulling funds from a traditional IRA or 401k before age 59 ? triggers a 10% penalty. But the CARES Act waived this penalty under certain pandemic-related financial hardships, allowing affected individuals to spread the tax impact of their withdrawal over three years or repay the withdrawal to avoid taxes altogether.
For 2020, the CARES Act also allowed withdrawals up to $100,000 without the 10% penalty and eliminated the mandatory 20% tax withholding on distributions.
Common Reasons for Early Withdrawals
– Education: IRAs allow for penalty-free withdrawals for qualified education expenses, which include tuition, books, and supplies for you or immediate family members. However, 401k plans might treat this as a hardship withdrawal, which can be penalized.
– First-Time Home Purchase: You can withdraw up to $10,000 from an IRA without penalty for a first-time home purchase. This rule also applies to immediate family members. 401k plans may allow for this as a hardship withdrawal but it’s often subject to the 10% penalty.
– Medical Expenses: Both IRA and 401k plans allow for penalty-free withdrawals if unreimbursed medical expenses exceed a certain percentage of your adjusted gross income.
Alternative to Early Withdrawals
If you absolutely must access funds, consider a 401k loan, which allows you to borrow against your 401k without a penalty, paying the interest back into your account. This is often more favorable than a straight withdrawal, which incurs taxes and potentially penalties.
The CARES Act increased the maximum loan amount from a 401k to $100,000 or 100% of the vested account balance, up from the usual $50,000 or 50%, with up to six years to repay under certain conditions.
Avoiding Early Withdrawals
The best practice is to avoid dipping into your retirement funds. Instead, explore other financial resources first:
– Savings accounts
– After-tax investments
– Side job income
– Loans from family or friends with no interest
– Personal loans with low-interest rates
– Roth IRA (you can withdraw your contributions tax- and penalty-free)
Developing alternative income streams, such as through real estate investments, can also help safeguard your retirement funds. By the time I was 30, I had invested in properties that now generate a significant passive income, and I’ve also diversified through real estate crowdfunding to capitalize on lower valuations and high cap rates.
Conclusion
It’s crucial to protect your retirement investments by avoiding premature withdrawals and focusing on building other savings and income streams. This strategic financial management will ensure that you can enjoy a stable and secure retirement.
