Iras, 401(K)S Can Be Useful Before Retirement Use Savings For Tuition, Other Solid Expenditures

If you use them right, your retirement savings can represent a versatile financial asset that isn’t always just for retirement.

But if you use them wrong, you can turn those same savings into a big mess.

The laws covering programs such as individual retirement accounts and employer-sponsored 401(k) plans were written to restrict their use for purposes other than saving for your “golden years.”

That’s why the rules provide, for instance, for a 10 percent penalty tax on distributions taken before the year in which you reach age 59-1/2, with a few exceptions.

The money in a retirement account can still function as a last-ditch emergency reserve, however, even if you’re younger than 59-1/2.

Suppose that you are out of work, and have no other savings to tap to prevent a mortgage foreclosure on your home.

Taking an early withdrawal from an IRA won’t cost you all that much in taxes, since you’re in a low tax bracket, and it may enable you to keep your house until you get a new job and are solvent again.

Beginning in 1997, people who are out of work may avoid the 10 percent penalty altogether on early IRA withdrawals that are used to pay medical expenses, if they satisfy certain conditions.

You can also dodge the penalty tax by following a plan of equal withdrawals each year based on your statistical life expectancy.

You cannot borrow money from an IRA, or pledge it as collateral on a loan. But many 401(k) plans and other employer-sponsored retirement plans do allow employees to borrow, subject to restrictions set by the employer.

The idea of borrowing from a 401(k) sometimes catches people’s fancy when they realize that they will, in effect, pay interest to themselves rather than a bank or finance company. “But it’s not always as smart a move as it appears,” cautions the Institute of Certified Financial Planners, a professional association.

First of all, money that is borrowed from a 401(k) stops earning returns from where it was invested before, and begins earning only the interest you pay out of your own pocket.

“You’re not earning money paying yourself back,” says the ICFP. “You’re using your own dollars. Furthermore, you’re paying back the loan with after-tax dollars. When you withdraw that money years later for retirement, you’ll pay tax on it again.”

Things can get nasty if you can’t keep up with the payments on a 401(k) loan. “Don’t borrow from your plan if you think you may be laid off or leave your job,” says Marcy Supovitz, vice president of retirement plans at Pioneer Mutual Funds in Boston.

“Normally you have five years to repay a 401(k) loan. But if you part company with your employer earlier, you may have to repay the loan immediately or owe federal income tax on the outstanding balance, plus a 10 percent early withdrawal penalty.”

No matter the details of your situation, loans taken from 401(k) plans should be used for important purposes only.

Says the ICFP: “Before borrowing, investigate all alternatives. If you do borrow, have the loan payments automatically deducted from your paycheck to lessen the chance of defaulting on the loan.

“Be sure the loan is for a substantial need, such as a financial emergency, the down payment on a home or college tuition. Don’t borrow to buy a television set or a night out on the town.”