Withdrawing from Qualified Plans: Pros, Cons, and Alternatives for Emergency Needs

By Rinaldo Crassa, CFP^®, AIF^®
Chief Operating Officer, HWMG; Financial Advisor, RJFS

Withdrawing from Qualified Plans: Pros, Cons, and Alternatives for Emergency Needs

One of the more frequent conversations I have with many people (including clients and potential clients) has been around the topic of withdrawing money from accounts earmarked for specific purposes, particularly retirement accounts. And generally, my answer has always been that it is not a good idea. One would be hard pressed to find any advisor or financial consultant that would recommend withdrawing monies from a qualified plan such as a 401(k), 401(b), IRA, etc.

It is important to consider and understand the implications of withdrawing monies from these plans and how the withdrawal will impact your finances. Before we discuss the disadvantages of this course, let us consider what the pros are for withdrawing from a qualified plan.

Firstly, it can provide quick access to cash to help with emergencies and unexpected medical expenses or necessary repairs. Secondly, by utilizing the funds available in a qualified plan, you can avoid using high interest debt (high-interest loans or credit cards) and adding another payment to your cash flow, which could already be stretched pretty thin.

But do these benefits outweigh the ramifications that come from this course of action. Whenever anyone withdraws from a qualified plan, there are three things to consider. They are:

1. Tax Implications,
2. Early Withdrawal Penalties, and
3. Impact on Retirement Savings and your ability to plan for the retirement you want.

Whenever you take money from a qualified plan (like a 401(k) or traditional IRA), that money is generally subject to ordinary income tax. This means the amount you withdraw will be added to your taxable income for the year and taxed at your current income tax rate.

Large withdrawals can push you into a higher tax bracket, increasing the overall tax rate you pay on your income for the year. It's important to consider the timing and amount of your withdrawals to manage your tax liability effectively.

If you withdraw funds before age 59½, you may be subject to an additional 10% early withdrawal penalty. This penalty is on top of the regular income tax you owe on the withdrawal amount. There are certain exceptions to the 10% penalty such as:

• Distributions made after reaching age 59½.
• Distributions due to total and permanent disability.
• Distributions made to beneficiaries after the death of the account holder.
• Qualified first-time homebuyer distributions (up to $10,000).
• Qualified education expenses.
• Substantially equal periodic payments (SEPPs).
• Medical expenses exceeding 7.5% of adjusted gross income.

And lastly, you have to consider the impact that the withdrawal will have on retirement plans, and your ability to retire in the manner you want to. For younger people, they may fall under the trap that they have the luxury of time on their side and will be able to make up that withdrawal over time with increased contributions to their retirement plans. But often, those plans to increase contributions do not happen because there are other priorities that come up (new home purchase, new car purchase, newborn child, etc.)

For those closer to retirement, the luxury of time is simply not available. Time not only affords the ability to put more away, but it also allows your portfolio the room it will need to recover from adverse market conditions when they happen, causing the portfolio to drop in value. This could then mean that retirement plans have to be delayed, or postponed, and often indefinitely.

So, what can be done to mitigate the need to go to a qualified plan for money. Well as is often the answer, a plan needs to be put in place. A plan that can help to create an emergency savings fund. A plan would also discuss alternative sources of funding that can be available:

• Personal loans,
• Home equity loans or lines of credit,
• Borrowing vs. withdrawing from a retirement plan

Before you go to money you have set aside for your future to fund an emergency today, consider the pros and cons, and ask yourself what else you can do.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. Raymond James does not provide tax services. Please discuss these matters with the appropriate professional.