Considering the widespread economic uncertainty and historic number of job losses amid the pandemic last year, it's understandable that many Americans either considered or already have withdrawn funds from their retirement accounts, including their 401(K) and IRA accounts.
And while nothing is more important that making sure bills are paid and food is on the table, there are alternatives and reasons why doing this moving forward should be a last resort.
TD Bank sat down with James Beam, Head of Investment Advisory for TD Wealth, to discuss the downsides to pulling from retirement accounts and what else people should consider if they need to become more liquid sooner.
Here's what he had to say:
1 – Find out if funds can even be taken out
"In certain situations, if you're working and contributing to your 401(K), you may not even be able to pull from it," Beam explained.
So, that should be your first step. Seeing if someone can take money out.
If not, then this becomes a moot point.
2 – Taxes and fees
If someone takes money out of their 401(K) before the age of 59.5, there are two main things to consider.
"That money is taxed as ordinary income," Beam said.
This means the funds that have been pulled add to someone's income for the year.
"But there's more," he added. "Pulling out of your retirement account could also put you in a higher tax bracket. You would potentially pay more taxes on your earned income."
Beam said there are also penalties associated with pulling from one's account early, as high as 10%.
3 – Compounding
The biggest loss could also come in the form of missed compounding, one of the best benefits of investing in retirement accounts.
Basically, over time, interest is made on investments, the gains are consistently compounded to grow larger over time. That's compounding in a nutshell. As the balance of a retirement account grows, so does the interest made on that account.
4 – A person can't put the money they take out back in
"Even if you're in a better financial position in the future, there are certain financial limits on what you can contribute per year," Beam explained.
He added, "If you take $20,000 out now, it's not like you can just put that back in six months later."
As a person signs up to contribute to their 401(K) for example, they'll see there's a limit on how much they can contribute to that account each year. The catch up becomes harder and could be nearly impossible in some cases, especially depending on how much is withdrawn.
"It's really tough to catch up once it's taken from your retirement account," he said.
5 – Other options
While every situation is different, the message here should be clear – speak to an investment professional or accountant or both to see what other financial vehicles are available to potentially help.
For example, a 401(K) loan is drawn directly from someone's retirement account, but it's not looked at as income, thus the borrower won't be taxed for those proceeds.
A vehicle like this will still cause a person to miss out on market returns but save them money in taxes and fees.
It's also flexible. The borrower can amortize it over a longer time period for things like a purchase of a home or can just take it out over an extended time frame (i.e., 5 years or longer) to pay it back.
There are also home equity loans and other means to consider what someone's earned or the equity they've built up to become more liquid.
In closing, everyone's situation is unique. Hopefully, this article can help serve as a guide or starting point in the conversation with their financial professional to determine which path is best for them.