There are several important rules to retirement planning. First, begin contributing to your account as early as possible. Second, pay as little in fees as you can to keep more of your money. Third, don’t touch your retirement fund until you’ve retired.
However, there are times when it may make sense to violate rule number three and take money out of your retirement account. Just remember that doing so, even for a good reason, can set you back financially when it comes to your retirement savings.
Here are some circumstances when it makes sense to withdraw money early from your retirement account:
As a First Time Home Buyer. First time home buyers are allowed to take up to $10,000 out of their retirement for a down payment or other initial housing expenses like closing costs. If you’re married, you and your spouse can each withdraw $10,000 from your accounts for a down payment.
Keep in mind that you won’t pay a penalty if you withdraw your retirement money for your new home, but you will still have to pay taxes on the amount withdrawn, unless you’re withdrawing from a Roth IRA. You’ll also have to use the money within 120 days of receiving the distribution.
If you have trouble saving enough money for a down payment, raiding your retirement fund can be a great way to become a homeowner, provided you know the financial risks of doing so. Carrie Schwab-Pomerantz, CFP and President of Charles Schwab Foundation, states, “Being able to take money from your IRA for a down payment is one thing—whether it’s the right thing for you is another. I caution you to think carefully. Raiding your retirement account can have long-term consequences. You’re losing the tax-free growth over time, and you’re depleting something that you’ve worked hard to save” (Charles Schwab).
If You’re Facing Bankruptcy. Taking out money to avoid bankruptcy may be right for you if you have limited debts. If there are a few debts hanging over you that you cannot pay, first negotiate with creditors to get the amount lowered. Then, you can focus on paying that lower amount.
If freeing yourself from these debts is all you need to get on your feet financially, you may want to pull money out of your retirement to pay for this. However, only withdraw if it won’t wipe out your retirement account. Ideally, you’d only need to tap a small portion of your IRA or 401(k) to pay off your debts, not a large amount.
You wouldn’t want to take this approach if you’re facing a long-term financial difficulty. If you’re several months behind on your house and car payments and you’ve also been unemployed for a year with no prospect of a job in the future, you wouldn’t want to raid your retirement. If you do need to file bankruptcy (and in this type of situation you might), your retirement accounts won’t be touched. There’s no sense in raiding your retirement if you’re going to have to eventually file for bankruptcy anyway.
To Pay for Education. You can withdraw money from your IRA or 401k to pay for qualified educational expenses for your child or yourself. Keep in mind that you won’t pay a penalty for withdrawing the money, but you will have to pay taxes, unless you withdraw from a Roth IRA. (You can avoid taxes with a Roth if you only withdraw your contributions, not the interest earned over the years.)
While this can be another way to pay for higher education, be careful if you or your child is receiving financial aid. “Withdrawals from 401(k)s and IRAs count as income for the year and could reduce the amount of financial aid the student qualifies for in future years. ‘If you’re doing this during the senior year of college, it will not have an impact, but if you do it in earlier years, it can have a severe negative impact on your financial aid,’ says Mark Kantrowitz, publisher of FinAid.org and author of Secrets to Winning a Scholarship. ‘Between the taxes and the reduction in need-based financial aid, you are potentially only going to net pennies on the dollar’” (US News).
The smartest move financially is to not touch your retirement accounts until you retire. The exception may be one of these three circumstances.
Have you ever taken an early withdrawal from your IRA or 401(k)? Would you recommend doing so?