Dipped into Your Retirement Account in 2021? Here's What Happens Next

Did you take a withdraw from your retirement funds in 2021 or contemplating a withdrawal? Here's what you need to know.

By Melissa Brock

Depositphotos.com contributor/Depositphotos.com - MarketBeat

This story originally appeared on MarketBeat

If you pulled money from your account in 2021, what does that mean for you?

Congress allowed retirement savers to take out as much as $100,000 from individual retirement accounts by the end of December 2020 without the 10% early withdrawal penalty (for those younger than age 59½). Fidelity Investments said that 1.6 million people, or 6.3% of eligible participants, took money out of their retirement plans with Fidelity.

But now that the end of December 2020 is a distant memory (a whole year ago!), what does that mean for you in December 2021? Let's find out.

What Happens When You Take Money Out of Retirement Accounts Early?

Here's what you'll need to remember when you take money out of your retirement accounts early.

1. You may owe taxes and other penalties.

If you withdraw from a traditional, rollover, SEP or SIMPLE IRAs before you turn 59½, the IRS considers it an early distribution. You'll have to pay federal and state taxes and a 10% penalty unless you plan to use the money for the following:

  • A first-time home purchase
  • Birth or adoption expenses
  • A qualified education expense
  • Death or disability
  • Health insurance (if you're unemployed)
  • Some types of medical expenses
  • Other possible reasons

If you take out money within the first two years of opening a SIMPLE IRA, you may face a 25% penalty. The IRS generally requires a 20% withholding of a 401(k) early withdrawal for taxes.

2. You may be able to remove your original contributions without penalty.

If you contribute to a Roth IRA, you can take out your original contributions without penalty.

How does this work?

Let's say you've contributed $10,000 to a Roth IRA over three years, which has grown to $2,000. You can take out the $10,000 without taxes and penalties. However, you cannot avoid taxes and penalties on the $2,000 of growth. You'll pay an additional tax of 10% unless five years have passed since you first contributed and as long as you've turned 59½. Your money must also go toward:

  • A first-time home purchase
  • A qualified education expense
  • Health insurance (if you're unemployed)
  • Some types of medical expenses
  • Death or disability has occurred
  • Other possible reasons

3. You disrupt compounding on your money.

It's really important to understand the effects that removing your money will have on your future. You'll lose out on compound interest, which is the effect of interest that builds on interest over time. This means a possible reduction of the overall amount of money available to you when you want to retire. You can't get compound interest "back" when you withdraw money early. Avoid taking a compound interest hit by considering alternative ways to "raise cash" instead of withdrawing your money.

3 Alternatives to Retirement Savings Withdrawals

Let's look at a few alternatives if you haven't actually taken a retirement savings withdrawal yet.

Alternative 1: Consider a 401(k) loan.

You can instead borrow money from your retirement savings account with the intent to pay it back. Instead of a withdrawal, you can take as much as 50% of your savings, up to a maximum of $50,000, within a 12-month period. The advantage is that you'll pay the money back so you don't face quite as big of a hit as you would with a complete withdrawal. In addition, you don't have to pay taxes and penalties with a 401(k) loan.

You'll usually have to pay the money back (with interest) within five years of taking your loan. Your plan will have specific rules about how much time you have to repay.

The downside is that if you leave your job, you'll have to repay the loan in full fairly quickly. You'll end up owing both taxes and a 10% penalty if you're under 59½, so it ends up looking a lot like a withdrawal.

Alternative 2: Consider a home equity loan or home equity line of credit (HELOC).

If you need money but want to avoid a retirement account early withdrawal, consider a home equity loan or a home equity line of credit (HELOC). A home equity loan is a second mortgage on your home. A HELOC operates a lot like a credit card. You can tap into a revolving line of credit and borrow as much or as little as you need throughout your draw period and up to your credit limit. You begin repaying the borrowed money as soon as your draw period ends. A home equity loan or HELOC may make sense if you're concerned about losing out on compounding on your retirement account and paying taxes and penalties.

The major downsides to home equity loans and HELOCs is that they are secured by your home. In other words, if you stop making payments on your home, you'll risk losing your home to foreclosure. On the other hand, you can use the money for whatever you want — whether you need to pay for medical expenses, have to fix a termite infestation in your home or another type of incident you may face.

Alternative 3: Consider a personal loan.

A personal loan may be another option to consider if you need money and don't want to sacrifice your hard-earned retirement savings. A personal loan might be a great option because your home doesn't secure the loan. Therefore, if you stop making your payments, a lender can't take away your home.

You'll repay with fixed payment terms. Though interest rates are often higher than home or auto loans, you'll pay far lower interest rates than you would pay for a credit card.

Consider All Your Options

When you need money, you may want to consider some alternative options before you land on withdrawing from your retirement account. Disrupting compounding on your retirement funds could land you in hot water later on.

If you've already dipped into your retirement funds early, know what that means for you. You may have to work harder to save money to make up for the money you've withdrawn.

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