The current housing crisis and other economic woes are taking their toll on people's wallets. Caught between escalating mortgage payments and rising fuel and food costs, many folks are having difficulty paying their bills. Not so long ago, some people probably would've just taken out a home equity loan, but with property values plummeting, their equity may already be exhausted – not to mention, those loans are now harder to get.
Which leads me to cite a disturbing behavior that's on the rise: Tapping long–term retirement savings accounts to pay short–term bills.
Loans and withdrawals from 401(k) plans, IRAs and other tax–sheltered plans are allowed in many cases but the financial consequences can be extremely costly, because of taxes, penalties and lost investment income.
Here are a few cautions to consider before raiding your nest egg:
401(k) loans. Many employer–sponsored 401(k) retirement plans let participants borrow from their account to buy a home, pay for education or medical expenses or for certain other reasons. Usually you must pay back the loan within five years (sometimes the timeframe is longer for home purchases).
However, if you miss payments or leave your job, you must pay off the loan immediately (usually within 30 to 90 days) or you'll owe income tax on the remainder – as well as a 10 percent early distribution penalty if you're under 59 ½. That 10 percent penalty could quickly erase any investment gains your account might have earned.
Another potential downside to 401(k) loans: Because you would now have a loan payment, you might be tempted to reduce your monthly contribution amount, thereby reducing your potential long–term account balance and earnings.
401(k) plan and IRA withdrawals. Some 401(k) plans also allow hardship withdrawals to pay for certain medical or higher education expenses, funerals, buying or repairing your home or to prevent eviction or foreclosure. You'll owe income tax on the withdrawal – and often the 10 percent penalty as well.
Unlike employer plans, traditional IRAs let you withdraw from your account at any time for any reason. However, you will be subject to income tax on the withdrawal – and usually the 10 percent penalty as well.
With Roth IRAs, you can withdraw the money you've contributed at any time, since it’s already been taxed. However, if you withdraw the interest earnings before 59 ½, you'll face that 10 percent penalty.
Further tax implications. Note that with 401(k) and traditional IRA withdrawals, the money is added to your taxable income for the year, which could bump you into a higher tax bracket or even jeopardize certain tax credits, deductions and exemptions that are tied to your adjusted gross income. All told, you could end up paying half or more of your withdrawal in taxes and penalties.
Compound earnings. Finally, if you borrow or withdraw your retirement savings, you'll lose out on the power of compounding, where interest earned on your savings is reinvested and in turn generates more earnings. You'll lose out on any gains those funds would have earned for you, which over a couple of decades could add up to tens or hundreds of thousands of dollars in lost income.
Bottom line: Think long and hard before tapping your retirement savings for anything other than retirement itself. If that's your only recourse, be sure to consult a financial professional about the tax implications; if you don't know one, www.plannersearch.org is a good place to start your search.
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