If You Have to Raid the Piggybank: IRA or 401(k)?

Q: I know you're never supposed to raid your retirement assets, but which one is less harmful in a real pinch--your IRA, or your 401(k) plan?
Anonymous

A: You're damned right you're not supposed to.  I can't believe I'm even answering this question, since there are few higher crimes in my mind than robbing your own retirement security.  Nonetheless, it does come up from time to time, so let's dive into all the implications...

I think everyone knows that workplace retirement plans fall into the 401(k), 403(b), SIMPLE 401(k), and 457 variety.  For the sake of ease, I will just refer to all of these as "401(k)s" and be done with it.

IRAs, for this purpose, will include Traditional IRAs, Roth IRAs, SEP-IRAs, and SIMPLE-IRAs

Also, I'm not discussing the possibility of borrowing from your 401(k).  I consider this to also be a sin, albeit a venial one.  More often than not, these end up as distributions when someone changes jobs.

Final caveat: there are some exceptions to the early withdrawal penalty (and, in some cases, any taxes at all).  I did an article on them here.

We'll go from worst to "best" choice (if there is such a thing):

The Worst: Your Workplace Pre-Tax Retirement Plan

Generally, when you raid money from your pre-tax 401(k) plan, you have made a distribution.  This will be subject to taxes plus a 10% penalty, for a potential tax rate approaching 50%.

Second-Worst: Your Pre-Tax Traditional IRA

The only upside here is that you have 60 days to return the distribution if you change your mind.  You also may have some non-deductible contributions that will at least give you some basis in the distribution.  Chances are, though, you'll be facing the same 50% tax rate as above.

Third-Worst: Roth Deferrals in Your 401(k) Plan

The deferral (though not the earnings on the deferral) will be free of tax or penalty, assuming you have had the Roth 401(k) set up for five years (which no one has yet).  The earnings on the deferral will face tax and the 10% penalty.

Best of the Worst: Your Roth IRA

Contributions can be withdrawn tax and penalty-free at any time.  Earnings on those contributions will face a 10% penalty and tax owed.  Of course, you also have the 60 days to change your mind.

The bottom line is to never, ever raid your retirement future.  However, if you must do it, go with your Roth.  Your first amount of money distributed will be considered contributions, and be free of tax or penalty.

Comments

[Robert D Flach]

I agree that “the bottom line is to never, ever raid your retirement future”.

However, many 401(k) plans allow participants to borrow from their account balance without a current tax cost. As long as the money is paid back to the plan before the employee terminates his employment there is no tax consequence. Basically you have borrowed money from yourself, and paid yourself interest on the borrowing.

The only problem with borrowing from a 401(k) is that if the money is not paid back and you leave the company the outstanding loan balance will be treated as a distribution and you will be paying regular federal and state income tax and probably a 10% premature withdrawal penalty as well.

I have had several 1040 clients over the years to whom this has happened. They changed jobs before paying back the 401(k) loan in full and received a Form 1099-R showing the balance on the loan as a fully taxable distribution. In probably all of my cases the client also paid the 10% penalty tax.

TWTP