Strapped for Cash?

At some point in our lives, most of us have felt a little strapped for cash.  Perhaps we suffered a job loss or unexpected medical expense.  But maybe we just overspent and are afraid to admit how much we really owe on credit cards.  Or possibly, we’ve decided it’s high time to replace the ‘89 Ford Aerostar that has 200,000 miles and probably just as many Cheerios stuck between the kid’s seat cushions. 

The days of using our homes as a piggy bank to bail us out are all but over.  Before approving home equity loans, lenders today require better credit scores, more home equity and higher income than they have in the past.  So where are Americans turning to finance college, upgrade their kitchens and get the debt collectors off their backs?  Their retirement plans.

Last month a survey released by Bankrate 1 shows that nearly one-fifth of full-time workers have dipped into their retirement accounts to cover a financial emergency in the past 12 months.  According to the survey, 19 percent of Americans have either borrowed or withdrawn funds from their retirement savings. 

Robbing Your Retirement: Early Withdrawal from your IRA/401k

When times are tough, making early withdrawals from your retirement funds can seem like a quick source of cash.  It is.  But it can be an extremely expensive source of quick cash and should really only be considered in cases of emergency.  Remember, we’re talking about your retirement plan, not your Aruba vacation plan!   So before you withdraw money from your retirement account consider the following traps:

Withdrawal Trap 1: Taxes and Penalties.  Money inside your deductible IRA or 401k plan has never been taxed.  Your contributions were made with pre-tax dollars and you’ve never had to pay taxes on interest, capital gains or dividends either.  But, once you take money out of the plan, it will be time to pay the piper.  When you withdraw money, you’ll pay taxes based on your current tax bracket – and the withdrawal might even cause you to jump into a higher bracket.   If you’re younger than 59 ½ and take a distribution, you may be subject to an additional tax of 10%.  Here’s an example highlighting the consequences of withdrawal.

Jane, age 51, wants to fund her Aruba Vacation.  She’s thinking of using the $10,000 account balance in one of her IRA’s to pay for the trip.  If she takes the distribution, the result could look like this:

IRA balance                                                                  $10,000

Federal Income Tax (25% rate)                                              - $  2,500

State Income Tax        (5% rate)                                  - $     500

10% early withdrawal penalty                                      - $  1,000

Total distribution amount:                                           $   6,000

Result:  In this example, Jane could lose up to 40% of her account balance due to taxes and penalties. 2

Withdrawal Trap 2: Less Money for Future Growth.  Obviously, when you withdraw a dollar, you have one less dollar available at retirement.  But more than this, that dollar is no longer earning interest so your account won’t have the opportunity to grow as quickly because your portfolio (and consequently your earnings) will be smaller.  You can never replace the missed earning opportunities.   

A Better Option: 401k Loans

Sometimes when you’re really strapped for cash and must get money from somewhere, a loan from your 401k plan can be a good idea because it’s a convenient and low-cost source for cash.  In general, you can borrow one-half of your plan balance up to $50,000.  You’ll have up to 5-years to pay it back and the interest you pay doesn’t go to a bank, but back into your own account.  If you do take a loan from your 401k, don’t borrow more than you absolutely need, and be sure to repay the loan as quickly as possible because when you pay the money back over a short period of time, is usually has little impact on your saving progress.

401k Loan Trap: Risk of Termination.  Know that if you leave your employer, most plans will require you to pay-off the loan within 60 days.  And if you’re unable to do so, the entire outstanding balance will be seen as a withdrawal and you’ll be taxed and penalized, accordingly.

The Best Option:  Create an Emergency Fund

Most experts agree that you should keep between three and six months worth of your living expenses set aside in an emergency fund.  Not only will this help should you experience a sudden loss of income, but it will also ease the burden of smaller emergencies such as repairing the brakes on your car.  If you currently don’t have one, make it a priority.  Open a savings account at your bank and set up automatic deposits where you contribute an affordable amount each month.  While this approach won’t help you if you’re strapped for cash now, it will give you peace of mind and provide a financial safety net for the future.

About this column: Steve Davis is a local CERTIFIED FINANCIAL PLANNER™ who has been helping clients for more than twenty years.  You can find out more about Steve and his company, Davis Financial at www.talkwithdavis.com 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

1  www.bankrate.com/finance/consumer-index/april-2011-retirement-savings

2 This example assumes all contributions to the account were tax deductible and contributions and earnings grew tax deferred. This example is for illustrative purposes only.

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