The customary advice about cashing out your retirement plan early is: don’t. There are very few situations that would make it financially worthwhile.
A standard IRA or 401(k) provides before-tax contributions and tax-free compounding, deferring taxes to retirement. A Roth IRA, although contributed to with after-tax dollars, provides for tax-free compounding and tax-free distributions in retirement, when you are likely to be in a higher tax bracket.
Penalties and Taxes
Barring a few exceptions, if you withdraw from an IRA or 401(k) prior to age 59 ½, you will incur an immediate 10% penalty on the amount withdrawn. In addition, with a regular IRA or 401(k), this distribution is considered income. Twenty percent will be automatically withheld, and the entire sum will be taxed at your regular rate. In fact, it could kick you up into a higher tax bracket, actually increasing your taxes for your entire income for the year.
Certain situations can exempt you from the penalty. For an IRA, you can usually withdraw money without a penalty in order to buy your first home, cover medical expenses, or pay for college tuition. A 401(k) is less forgiving: you can only withdraw early if you’re over 55 and not working at that company and the money you withdraw is being used for medical bills or a divorce settlement.
Why You Should Still Avoid Early Distribution
Still, if you can avoid early distribution, you should. Here’s a scenario: You’re 36 years old and you withdraw $10,000 from your IRA. You lose $1,000 immediately, plus another $2,000 goes right to Uncle Sam. You now have $7,000 (which may still incur more taxes on Tax Day). But you’ve really lost a great deal more money than that. If you left that $10,000 in there for another 30 years, at 6% compounding annually, it would have grown to $57,400!
Try to find another way to cover your expenses, even if they’re allowable distributions. Calculate the costs of a loan versus the cost of losing all of that compounding value, growing tax-free. You can even borrow from your retirement plan as long as you are able to pay it back within a given timeframe – usually within the year. Talk to your plan advisor or trusted accountant to consider all the options and financial effects of your decision.