Should I Withdraw Money from My 401(k) or IRA?

Should I Withdraw Money from My 401(k) or IRA? article image.

When finances are tight, taking money out of your retirement savings can be tempting, especially if you've created a sizable nest egg. But withdrawing money from your 401(k) or individual retirement account (IRA) comes with consequences.

Pulling money from your 401(k) or IRA can tide you over until your financial squeeze eases, but it might not be the best way to boost your bank account. Since drawing money from your retirement accounts reduces their balances, doing so could jeopardize or delay your retirement. Therefore, it's best to weigh other options, such as a personal loan or a credit card with a 0% intro offer, when you're seeking a cash lifeline.

Here's what you need to know before you drain money from your 401(k) or IRA.

What Is a 401(k) or IRA Withdrawal?

Typically, an early withdrawal from a 401(k) or IRA can be done when you're facing what the IRS describes as "an immediate and heavy financial need."

What are the circumstances when you might qualify for a 401(k) withdrawal before age 59½? Examples include:

  • Out-of-pocket medical expenses
  • Home purchase
  • College tuition, dorm fees and related costs
  • Prevention of an apartment eviction or home foreclosure
  • Funeral expenses
  • Some home repairs

For a traditional IRA, you might be eligible for a withdrawal before age 59½ to:

  • Cover expenses related to a birth or adoption
  • Pay health care expenses that can't be reimbursed
  • Make a first-time home purchase
  • Cover college expenses
  • Pay for health insurance when you're unemployed

If you withdraw from a 401(k) plan, you'll pay a 10% penalty and income taxes on the amount withdrawn. When you withdraw from a traditional IRA, you'll pay a 10% penalty on the amount withdrawn.

If you have a Roth IRA, you can often make a tax-free and penalty-free withdrawal before age 59½ for certain things, such as a first-time home purchase, birth or adoption expenses, or college costs. Otherwise, taxes and penalties likely will kick in if you withdraw money before age 59½.

Withdrawals from all of these accounts also are allowed when an account's owner dies or becomes disabled.

What Is a 401(k) Loan or IRA Loan?

With a 401(k) loan, you can borrow money from the account for most any reason. You would repay that money just as you would with a traditional loan. You're not allowed to take out a loan from a traditional or Roth IRA.

You won't pay any income taxes or penalty fees on the 401(k) loan amount. You will be charged interest on the loan, though. Fortunately, the interest payments are funneled back into your 401(k) when you repay the loan.

A 401(k) loan doesn't involve a lender such as a bank or credit union. A credit check isn't required, and your credit reports and credit scores aren't affected. You can borrow as much as 50% of your vested 401(k) account balance or $50,000, whichever is lower.

Once you authorize the loan, you'll receive it in your next paycheck or in your checking account if you have direct deposit.

How Are Withdrawals and Loans Different?

When you withdraw money from a 401(k) or an IRA, you're not required to pay it back. But when you take out a 401(k) loan, you're borrowing the money, so you are required to pay it back.

You're usually given five years to pay back a 401(k) loan. If you're using the money to buy a primary residence, you might be eligible for a 25-year payback period.

The main difference between a loan and a withdrawal, however, is that with a loan, you pay back your retirement account so it can begin earning money for your retirement again. Because you don't pay back a withdrawal, that money is no longer working toward your retirement savings—unless you are able to invest it at a later date in a traditional IRA or Roth IRA plan.

Should You Withdraw From Your Retirement Account if Cash Is Tight?

Generally, financial experts advise against taking money, whether in the form of a withdrawal or loan, out of your 401(k) or IRA. That's true even now during the COVID-19 (coronavirus) crisis, which has shuttered millions of businesses in the U.S. and put millions of Americans out of work.

New Rules in the Coronavirus Era

Amid the COVID-19 pandemic, the federal government has loosened the requirements for pulling cash from your 401(k) or IRA. This is designed to help people who have become ill or have lost income due to the virus outbreak, or have otherwise been affected by the virus and its economic fallout.

The federal Coronavirus Aid, Relief and Economic Security Act (CARES) Act provides relief to Americans, businesses and others injured by the crisis. Under that law, Americans facing financial hardship due to the coronavirus can make penalty-free 401(k) or IRA withdrawals. They also can take out a less-restrictive 401(k) loan.

The CARES Act lets anyone who has enough money in their account, regardless of their age, pull as much as $100,000 from a 401(k) or IRA without being charged the usual 10% early withdrawal penalty. If you redeposit the cash within three years, you won't need to pay taxes on the early withdrawal. If you miss that window, you can pay the tax bill over a three-year period.

The CARES Act also relaxes restrictions on 401(k) loans for people who've suffered financially during the coronavirus pandemic by raising the amount you can borrow. Now, you can borrow 100% of your vested account balance or $100,000, whichever is lower. Another change: You can now pay off a 401(k) loan over six years, up from five years.

Reasons to Avoid Withdrawing Money From Your Retirement Account

Whether you're experiencing financial trouble due to the ongoing coronavirus emergency or a different personal emergency, most financial advisers strongly recommend against tapping into your 401(k) or IRA to soften the blow.

Why? Here are six reasons:

  1. The money you withdraw or borrow won't grow since it's not being invested. That means it could take more time to build your retirement nest egg.
  2. Pulling out when the stock market is down (as it is during the coronavirus outbreak) reduces the value of your investments.
  3. If you take out money, you'll miss out on realizing investment gains when the market picks up.
  4. Fees for a 401(k) loan could exceed the fees you'd pay for a conventional loan.
  5. Repayments for a 401(k) loan are made with after-tax dollars that will be hit with taxes again when you withdraw the money down the road.
  6. You could be dinged by fees and taxes. While the CARES Act gives some leeway on fees and taxes, you normally must pay a 10% penalty for an early withdrawal from a 401(k) or traditional IRA. In addition, you must pay income taxes on the money you've withdrawn.

The Case for Pulling Money from Your Retirement Accounts

In some instances, however, taking money out of a 401(k) or IRA might be your best bet.

For example, if you've been laid off and lack an emergency fund or a backup plan, you could be struggling to pay rent, buy groceries and cover other necessities. In that situation, pulling cash from a 401(k) or IRA might be the only way you can keep a roof over your head and food on your table.

Keep in mind that most financial advisors say these withdrawal and loan options should be a last resort.

Speaking of resorts, it's not a great idea to pay for nonessential expenses like a vacation with money from a 401(k) or IRA. Likewise, you should steer clear of a withdrawal or loan from your retirement account to buy new furniture or cover wedding expenses. First and foremost, your retirement account should be reserved for your retirement. It's best to save up for a vacation, new furniture or wedding by setting up a bank account solely for that purpose and carefully budgeting.

What Are the Alternatives to a Retirement Withdrawal or Loan?

When it comes to borrowing money, you've likely got other options before you if your credit is in a good place. Before you resort to withdrawing or borrowing money from your 401(k) or IRA, investigate these alternatives:

Bankruptcy is another option. But you should exhaust all other alternatives before seriously considering bankruptcy. As long as a bankruptcy stays on your credit reports, it'll be harder to obtain credit. Furthermore, it could hurt your ability to rent an apartment, sign up for utilities or get a job.

Visit with a credit counselor or financial adviser before diving into bankruptcy.

The Bottom Line

Before you look at taking money out of a 401(k) or IRA, take a look at the alternatives—and at your future.

Would you be able to make it through your financial crunch by relying on an emergency fund or cutting your budget? Or have you exhausted other options and face an immediate future that would be too rough without tapping into a retirement account? And how soon do you plan on retiring?

If you do settle on a 401(k) withdrawal, IRA withdrawal or 401(k) loan, try to get back on track with your retirement investing as soon as you can. And if you borrow money from your 401(k), aim to repay the loan as quickly as possible. These moves will help you build a stronger nest for your nest egg.