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4 Things to Know Before Raiding Your Retirement Plan

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Life can be full of financial surprises. Imagine that you’ve been told that both your furnace and roof need replacing, and your car requires expensive repairs. On top of that, your spouse has stopped working due to illness, and the medical bills continue to mount.

Unfortunately, you’ve already drained your small emergency fund. Or you didn’t get around to building one. Whatever the reason, you need to come up with some serious cash right now.

Many Americans are in a similar bind. According to “Inside the Wallets of Working Americans,” a recent survey by Salary Finance, 45 percent of the 3,000 respondents reported that they feel financially stressed, 55 percent said they’ve had less cash on hand over the past 12 months than in the previous year, and 68 percent reported they don’t have money set aside for emergencies.

Your first impulse may be to tap your retirement fund. In the Salary Finance study, 18 percent of the respondents said they had just done so.

After years of contributing to your 401(k), 403(b) or 457, you’ve accumulated a nice nest egg. But should you borrow from it? How do these loans work?

While there are some advantages, B. Kelly Graves, a certified financial planner (CFP) and executive vice president at Carroll Financial Associates in Charlotte, North Carolina, advises against it. “You’ll be withdrawing money from investments that may be earning a nice return. And it’s too easy to not repay a loan, which would ultimately hurt your retirement.”

What if you just withdrew the cash you need instead? The decisions you make now as you face a temporary cash crunch will affect your financial future.

1. An early distribution is the most expensive option

Simply withdrawing funds from your retirement account would be costly if you haven’t yet reached age 59½, says Chris Chen, a CFP at Insight Financial Strategists LLC in Lincoln, Massachusetts. “You’d be required to pay federal and state income tax on those funds, plus a 10 percent early withdrawal penalty. The actual cost would depend on your tax bracket.”

For example, if your federal tax bracket is 22 percent, the penalty would make it 32 percent. Add the 5 percent state tax in Massachusetts, or the 13 percent state tax in California, for example, and your tax would come to 37 percent or 45 percent, respectively. That’s expensive money.

Doing so may also hurt you down the road, Chen says. “People rationalize that they will put the money back into their retirement account when their cash flow is better. When will that be?”

2. Retirement plan loans have costs, risks and few benefits

​If you decide to take a loan instead, the amount will be limited to $50,000 or 50 percent of your vested account balance, whichever is less. You’ll be selling shares to generate cash, with five years to repay the loan. As you do, you’ll buy back shares, likely at a higher price. “You may miss the best days and years in the market,” says Paresh Shah, a CFP at PareShah Partners LLC in Hicksville, New York.

You’ll also pay interest, but you’re paying it to yourself. You can easily pay off the loan via payroll deduction — but you will pay with after-tax dollars. Taxes will be due again when you take qualified distributions in retirement.

What’s more, it’s likely that you won’t have the money to continue regular contributions to your account. In fact, some plans require you to stop contributing for a time after the loan.

Should you leave your job — voluntarily or not — you’ll be required to repay any outstanding balance within a year. Otherwise, the IRS will consider it a distribution and you’ll owe taxes on it. If you’re younger than 59½, you’ll pay a 10 percent penalty on top of income tax.

What are the benefits? The money won’t be taxed if you follow the rules and the repayment schedule. “Also, it may be a lower-cost alternative to other sources of cash, as the interest rate may be lower,” says Nicole Sullivan, a CFP at Prism Planning Partners in Libertyville, Illinois. “And it won’t affect your credit report.” But you’d better create a plan to pay it off, and stick to it, Chen says. “The longer you postpone putting the money back, the more growth you’ll be giving up.”