I know it’s hard. I know you’re desperate. You’re stressed and losing sleep. Things are tough. You have to do something, and soon. But whatever you do, don’t touch your retirement account. Don’t borrow against it. Don’t withdraw from it. Just leave it alone.
What’s so bad about liquidating a retirement account? Here are five reasons you’ll quickly regret doing that:
Momentum. Your retirement account, even during times when it appears to be losing value, is money you are going to need when you reach retirement age. And I can guarantee you are going to need it much more then than you do now. If you bleed it dry now, you stop the momentum — the pace at which it is growing. Think of your retirement account as completely out of your reach for now.
Penalties. This is huge. The penalty for early withdrawal (before you are 59 1/2) is severe. You will lose 10% right off the top. If you don’t think that is significant, you are not thinking straight. Calculate how long you will have to work and contribute in the future to make up for this loss.
Taxes. If you think you’re losing sleep now, just wait until you owe back taxes on a retirement withdrawal. You have to pay income tax on the entire amount all at once — both federal and state if you live in a state that taxes income. Let’s say you cash out a $50,000 retirement account before age 59-1/2.
You will get a check for $45,000 (the 10% penalty is collected before distribution). Then you should expect to pay about $16,000 in taxes, leaving you $29,000 of the original $50,000 and nothing left for retirement.
Loss of exemption. The New York Times reports, “A unanimous Supreme Court ruled that federal bankruptcy law shields individual retirement accounts from creditors ... the same protection in bankruptcy that higher-paid workers receive for their 401(k) plans and company pensions.” That decision boosts protections for the nest eggs of millions of people.
That means no matter what happens or how bad things get before you turn the corner and get back to work, creditors can’t touch it. And more importantly, if, God forbid, you have to file a bankruptcy case, it means that no matter what, the trustee can’t touch your retirement account.
Double taxation. The benefit of a traditional 401(k) account is that you get to contribute and invest pretax dollars. You get to defer taxes until you take the money out in retirement. If you borrow now, you must repay the loan with after-tax dollars. Are you with me?
If you borrow, say, $10,000 from your retirement account, you will have to earn about $13,000 gross to end up with $10,000 after-tax to repay the loan. You don’t get to repay with pretax dollars, so that’s the first taxation. Then, when you retire, you will pay tax on the same $10,000 — taxation number two.
All money in traditional retirement accounts is taxed upon withdrawal regardless of if the funds were borrowed and then paid back with after-tax dollars.
n Too risky. It is just too risky and expensive to cash in or even borrow from a 401(k). If you are really strapped, you could halt contributions to your account temporarily, while leaving the balance alone to grow. That would beef up your paycheck with more money until the storm passes by.
No matter how difficult things are right now, cross your retirement account off your list of options. Stop thinking of your 40l(k) account as your personal ATM machine. It is out of your reach for now. Then, get busy pursuing every other option that you have.
As difficult as things may be right now or may become in the future, I promise that in 10 years you’ll thank me.