New Parents Taking Penalty-Free Withdrawals from Retirement Accounts (Q & A)

Jan 2020

 

Dear Rick:
My husband and I are expecting our first child, hopefully by the end of the month. My husband and my original game plan was that once I had a child, I would stop working. Unfortunately, after going through our finances my husband and I both realize that that was not practical. Therefore, our current game plan is for me to take a leave of absence from my job for six months. Because I will not have any income for that six-month period, we will need some extra money. My guesstimate is that we’ll need anywhere from $7,000 to $8,000. We have a few different options and I hope you will be able to help me select the best one for us. The first is to take a distribution from our IRAs. In that regard I do recognize that I would have to pay the 10 percent penalty. The second option is to take out a personal loan. I went on one of those internet sites and have been approved for a loan. The interest rate on the loan is 8¼ percent. My question to you is, what option do you think is best in my situation?

Thank you.

Carol

Dear Carol:
First of all, and most importantly, congratulations on your future addition to your family. In that regard, I want to remind you how important it is that you and your husband do a will. It is important that when you have a child you do a will so you can name a guardian for your child, if in the unlikely event, something happens to you and your husband. As a parent, you have responsibilities to your child and doing a will is one of those responsibilities. Remember you don’t necessarily have to pay an Attorney to draft a will. Michigan has a free will The Michigan Statutory will that probably will fit your needs. You can get this free will in many places including on my website at Bloomassetmanagement.com.

In reviewing your two options, I am not a fan of the second option where you are taking out a personal loan at 8¼ percent. Eight-and-a-quarter percent is a high interest rate, particularly, when you consider that that money is not tax deductible. In addition, when you take out a personal loan, you have to start making immediate payments. I certainly wouldn’t want those payments to cause you any additional financial stress. Therefore, taking out a personal loan is not an option I would recommend.

With regards to taking money out of your IRA, there is some good news for you. The SECURE Act, the new law that took effect at the beginning of this year, has a new exception to the rule with regards to early withdrawals from your IRA. Under the new SECURE Act, which the President signed in December, parents who just had a baby or adopted a new child are now allowed to take out up to $5,000 out of their retirement plan or their individual retirement account without having to pay the 10 percent penalty. The $5,000 limit applies to each parent; therefore, a couple can take up to $10,000 penalty free from their retirement accounts with one year from the birth or adoption of a child.

In reviewing your two options, I definitely believe withdrawing from the IRA is your best solution. However, it is important to keep in mind that you will still have to pay the taxes on the withdrawal. It is only the 10 percent early distribution penalty that is waived.

In general, I am not a big fan of someone withdrawing money from their retirement account before retirement. After all, retirement funds are for retirement. If you start drawing down from your retirement savings before retirement, what are you going to have when you retire? Therefore, even though the new law allows new parents to borrow from their retirement accounts, they should proceed with caution.

One last note regarding the situation at hand, under the new SECURE Act, parents who do take advantage of the new law and take an early withdrawal from their retirement account can opt to repay the withdrawal amount.

Good luck!

 

Rick is a fee-only financial advisor.  If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com