Many financial experts recommend contributing to retirement accounts because they have excellent tax incentives. For example, IRS rules allow 401(k) plan participants to make tax-deferred contributions that will grow without the drag of taxes until retirement. Withdrawals are taxed at regular income rates. Traditional IRA's offer a similar tax benefit. Roth IRA’s and Roth 401(k)’s also have great tax advantages: You pay taxes on the income now, but don't pay taxes on the money you deposited or the interest when you make withdrawals.
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These incentives exist because the government wants individuals to take more control of their retirement income. But the government would prefer that you leave your money in your account until retirement. If you decide you need the money sooner than that, you might face an early withdrawal penalty. And that may not even be the worst part of withdrawing retirement funds early. Here’s a look at the negative consequences of an early distribution of retirement funds.
Early withdrawal penalties. Many retirement savings plans limit penalty-free withdrawals to those age 59 1/2 and older. It is important to avoid making withdrawals before that age. If you do, you will be slapped with an early withdrawal penalty of 10 percent and income tax based on the amount of money you withdraw. This can substantially reduce the amount of money you have working toward your retirement goals.
Risky retirement account loans. Many retirement plans offer participants the ability to take a loan from their account. This can be tempting, but try to avoid it. In most cases you can borrow up to half of your contributions up to $50,000 with five years to repay the money. This might seem like a viable alternative to a traditional loan because you are basically paying yourself back with interest. The downside of this option is that if you leave your job, either voluntarily or involuntarily, your loan must be paid back in full immediately or you will owe penalties and fees (not to mention never be able to get that money back into your retirement account). In this struggling economy where no job is safe, this is a risk best avoided whenever possible.
Loss of growth opportunity. One of the biggest negatives of tapping your retirement account early is the lost opportunity for growth. Many people do not consider how much their money could be working for them if they left it alone in the account. Compound interest is a valuable resource that will help propel you toward a secure retirement. Withdrawing your retirement investments means your money isn't working for you.
If you are struggling and need an influx of cash it is usually better to seek out alternatives before making an early withdrawal from a retirement account. If you decide you have no other alternatives, my recommendation is to at least consult with a tax professional or financial planner. He or she will help you understand the current and future tax consequences of an early withdrawal. What seems like a great idea today might not be such a good idea in the long run.