With the coronavirus pandemic upending lives, the temptation to dip into retirement assets such as IRAs and 401(k)s early can be powerful, especially for those facing unemployment or unexpected medical expenses.
But these types of accounts were designed to be treated much like a crop. Plant seeds. Provide light, water and fertilizer consistently. Let grow. Harvest when ripe.
With retirement accounts, as with crops, there are opportunities to harvest prematurely – but potentially negative consequences for doing so.
Under federal rules, people with a qualified retirement account such as a 401(k) or a traditional IRA (Individual Retirement Account) can start withdrawing funds from their account at age 59½ and must take distributions starting at age 72.
Withdrawing money from a qualified retirement account prior to age 59½ means the account holder will probably have to pay state and federal income tax on the amount withdrawn, in addition to a 10% tax penalty.
But the drawbacks to withdrawing money early from a retirement account extend well beyond tax penalties. For one, an early withdrawal sacrifices the growth potential of the assets that are withdrawn: You lose out on the compound growth potential associated with those assets. The assets held in a retirement account have the potential to compound in value without taxes eroding that value. Over time, earnings can compound upon earnings, providing the growth engine that people rely on to build enough assets to last through retirement.
For 401(k) account holders, early withdrawals must be in the form of a loan that must be repaid over time. So, the withdrawal comes with a payback obligation as well as a tax obligation and a penalty.
In certain rare situations, however, a retirement account could be a person’s last financial resort – their only means of covering basic living expenses, or dealing with an unexpected severe financial challenge. In those situations, survival is more important than retirement, and a premature withdrawal could be warranted.
There also are rare situations when making a series of early withdrawals, called SEPPs, under Rule 72(t) in the federal tax code, may make sense. The rule exempts taxpayers from early-withdrawal penalties provided they take account withdrawals in at least five installments over five years. This could be an option for people who retired prior to age 59 1/2.
Before deciding to tap a retirement account early and live with the consequences, seek advice from a financial professional about other potential options. Often, there’s a better alternative.
During situations in which early retirement account withdrawals are a consideration, there is no one-size-fits-all strategy. Working with a financial planner will help you find the best solution for your unique situation.
JASON E. SIPERSTEIN, CFA, CFP, is the president of the Financial Planning Association of Rhode Island and president of Eliot Rose Wealth Management. He can be reached by email at firstname.lastname@example.org.