It is not surprising to learn that smart investors understand early on that saving for retirement is crucial to ensure a successful retirement, and in particular the benefits of allowing your savings time to grow over decades. The power of compound interest, when allowed to perform over the long haul without interruption, can allow you to accumulate significant savings by the time you retire without having to sacrifice your standard of living during your working years. And financial experts agree almost unanimously that the funds you set aside for retirement should be revered and left untouched.
After all, your retirement fund is for retirement, right? You’re not supposed to touch it until you are at least 59 ½ . That’s why the IRS usually imposes a 10% penalty on early withdrawals from qualified accounts like 401(k) plans and Individual Retirement Accounts (IRAs) before you reach that magic age. But sometimes unforeseen expenses pop up and those accounts make a tempting target to alleviate our short-term pain.
Because we don’t live in a perfect world, we may face financial situations out of our control. Heck, many people have experienced a financial setback at least once during their working years and everyone – regardless of their income or assets – is susceptible to them. Get this, 3 in 10 Americans said they took cash from retirement accounts during the early months of the pandemic, and the majority of those did so to cover household expenses and groceries₁.
So, before you start draining your retirement savings, let’s dig into some alternative ways to help make ends meet during times of financial crisis.
For example, start by studying your expenses. When the pandemic hit, you probably spent less on certain categories, such as travel, recreation and commuting. You could decide to continue cutting back on those areas post-pandemic too. You can also look for different streams of income. Many Americans are picking side hustles and gig work if they have some free time, so that could be something to consider if you need to generate some cash. If you’re fortunate enough to have some savings set aside, uncashed bonds or even buckets of loose change, now might be the time to tap into those options.
Once you’ve considered these and other possibilities, if you still decide to take funds from your 401(k) or other retirement accounts, be sure to understand the rules of the road to help minimize the damage. Let’s review the specifics.
For starters, you need to understand that retirement accounts are designed to encourage folks to put aside funds for the long term for retirement, so the law typically requires people who withdraw money from these accounts before age 59½ to pay ordinary income taxes plus a stiff 10% penalty. But the cost of early payouts can vary widely, so consider these facts.
You can take a withdrawal from your IRA account and avoid the 10% penalty tax if the funds are used for higher education expenses, first-time home buyers ($10,000) and the cost of health insurance for many people who are unemployed. And folks under age 59½ avoid both income taxes and the 10% penalty on early withdrawals if they are from dollars that were contributed to Roth IRAs (but not the earnings on that money). You can’t do this with your 401(k).
However, 401(k) participants have a few options of their own. For example, the 10% penalty doesn’t apply to workers who retire in the year they turn 55 or later and make withdrawals before age 59½. They will owe ordinary income taxed but not the 10% penalty.
And many 401(k) plans allow employees to borrow and pay back the loan within five years. You need to be careful here though, because if you leave the company, then the outstanding loan balance is due immediately. If you don’t pay it back, it will be considered a withdrawal and fully taxable.
For both the 401(k) plan and the IRA, there are also full exceptions for death, disability and terminal illness, as well as for medical expenses exceeding 7.5% of savers’ adjusted gross income. Exceptions also apply for birth or adoption expenses ($5,000); qualified disasters ($22,000); and domestic abuse victims ($10,300).
Another option is called the “Rule 72(t)” and allows for payments from IRAs or 401(k)s without the 10% penalty. IRS code IRS 72(t) specifies exceptions to the early-withdrawal tax. Under this option, the owner of the retirement account must take at least “five substantially equal periodic payments”, and the amount of the payments depends on the owner’s life expectancy as calculated through IRS-approved methods. Again, you need to understand all of the requirements here because if you miss a payout, then the taxes, interest, and the 10% penalty could be due retroactive to the beginning of the arrangement. The payments must last until at least age 59½, and sometimes longer.
Folks, financial challenges are an inherent part of life, but understanding your options can help you minimize their damage.
So as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA.
Insurance offered through its affiliate, CutterInsure, Inc. We do not offer tax or legal advice. Jeff can be reached at jeff@cutterfinancialgroup.com. This information is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject of the article. Different types of investments involve varying degrees of risk, including the potential for loss. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Insurance product guarantees are backed by the financial strength and claims-paying ability of the issuing company. Market data and other cited or linked-to content is based on generally available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Cutter Financial will provide all prospective clients with a copy of Cutter Financial’s Form ADV 2A, Appendix 1, applicable Form ADV 2Bs and Form CRS as well as the firm privacy policy. Please contact us to request a free copy via .pdf or hardcopy. 1. https://tinyurl.com/yntuytan
