Taking an early withdrawal is not only costly in the short term, it can also jeopardize your long-term retirement goals: You'll be forfeiting the benefits of tax-deferred earnings and compounding interest, which diminishes the savings power of these accounts. These plans are specifically designed for long-term investing, making the years work in the contributor's favor.
Because of the severe financial penalties, withdrawing money early from retirement accounts should only be done in an extreme emergency, ideally after any emergency funds and investments have been depleted. Certain qualifying situations allow for a penalty-free hardship withdrawal, but employers are not required to offer that benefit and some people just have to take the hit to stay financially afloat.
Emily LaRusch, founder of Back Office Betties, has experienced this firsthand. "In 2010 I was days away from having my second baby when I was laid off. I made the decision to close my 401(k) and accept the penalties in order to support my family while I stayed at home for the first year with my son," she said.
If you are in a financial pinch and considering taking money out of your IRA or 401(k), here are seven times it's OK to dip into your retirement fund early.
1. You become totally and permanently disabled.
You can take penalty-free distributions from qualified plans due to a total or permanent disability; minor or partial disabilities don't qualify. According to IRS Publication 590:
You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued and indefinite duration.
Some experts recommend first applying for state disability insurance to make it easier to prove your status to the retirement plan administrator.
2. You're drowning in medical debt.
You can withdraw from your retirement accounts to cover out-of-pocket medical expenses that exceed 10 percent of your adjusted gross income. These expenses must be paid in the same year you take the distribution and the distribution is not subject to penalty of tax if withdrawn from an IRA.
3. You're getting divorced.
If you get divorced you might be required by court to divide the funds with your former spouse or a dependent. These distributions are usually ordered under a property settlement under a qualifying domestic relations order and are penalty-free.
4. You're starting a business.
Many personal finance experts will probably advise otherwise, but you may be able to use your 401(k) and IRA funds to finance a small business or startup. This isn't a simple process and there are significant legal steps you will need to take, including rolling the money over into a corporate retirement account that allows you to invest in the business. It's best to consult a financial planner or third-party retirement-plan administrator for help with this.
For some, this move has been well worth the effort and extra risk. Jason Fisher, cofounder of The Life Insurance Blog, drained his 401(k) to start his business. "I tapped out my entire 401(k) to begin a small business. While it wasn't a ton of money, it was crucial for my business to have as much capital up front as possible, and the hit I took in penalties and taxes was well worth it," he said. "The way I look at it, I was able to compound my money in a business much faster than anticipated in the market, and I was correct. Obviously, the risk was greater, too."
5. You're purchasing your first home.
You can take up to $10,000 from your IRA free of penalty to purchase your first home. The money can be used for acquiring, building or reconstructing a residence for the account holder, spouse, children, grandchildren or ancestors. You are considered a first-time homebuyer if you have not owned a home for the last two years.
It's important to note that the $10,000 limit is per person, so if two people are purchasing the home, you can take out twice as much. Ian Aronovich, president and cofounder of GovernmentAuctions.org, shared his story: "About two years ago we pulled roughly $20,000 from our retirement funds — not as a loan but as a distribution, to help with the purchase of our first home. Since a $10,000-per-person withdrawal is allowed without an early withdrawal penalty when used to buy your first house, it made perfect sense."
6. You need to pay for higher education.
This only qualifies for students that are at least 18 years old, and the funds must be used for tuition payments. Financial advisors usually recommend account holders invest more heavily in retirement accounts than 529s to maximize eligibility for financial aid, since colleges don't consider retirement accounts when determining how much aid you qualify for.
Also, 529 contributions don't yield a federal tax deduction, so this tactic might also reduce your federal tax bill, although there are state income tax deductions associated with 529 contributions. Depending on whether you are withdrawing from a 401(k) or IRA, different rules regarding loans and adjusted gross income apply, so this must be carefully thought out and timed. Consider consulting a professional for help.
7. You are facing foreclosure.
In previous years, homeowners would use home equity lines of credit as a resource to avoid foreclosures. The post-recession economy has taken that option off the table for many and their next best option might be using retirement savings to bridge the gap. Many IRA and 401(k) plans allow you to use the funds to prevent foreclosure on your primary residence. You can either borrow the money and pay it back within a specific time frame or just withdraw the money. You might pay penalties and tax, so consult your plan administrator before you make the decision.
The Bottom Line on Withdrawing Retirement Funds Early
Withdrawing money early from your retirement accounts carries heavy financial consequences, but sometimes the benefit outweighs the cost. This is as an opportunity to assess your financial situation: Are these problems only temporary or the sign of a much larger issue? Make a new financial plan that will protect you from facing this difficult and costly decision again in the future.
This article was contributed by Morgan Quinn of GOBankingRates.com, a leading portal for personal finance news and features, offering visitors the latest information on everything from strategies on saving money to getting out of debt.