Becoming a parent or adding a baby, while an exciting time, can also be stressful. Of course, there are the sleepless nights and the round the clock baby care, but there are also financial considerations. Many people are surprised how many expenses come with the birth of a baby. And, you must also consider who will care for the child. In the United States, maternity and paternity leave are not universal. If you or your partner want to stay home for a few weeks after the baby is born (or adopted) and you don’t have maternity/paternity leave, you’ll either need to save money for it or find a way to cover your expenses while you stay home. If you fall into the latter category, it’s important to learn how new parents can tap their retirement savings penalty free.
Thank the SECURE Act
The SECURE Act (short for The Setting Every Community Up for Retirement Enhancement Act), which passed in December 2019, now allows parents who’ve had a baby or adopted a child within the past year to take up to $5,000 out of their retirement account penalty free. If each parent has their own retirement account, each individual can take out $5,000, meaning the couple can take out $10,000 total.
Normally, if a person takes money out of their retirement account before 59.5 years of age, they have to pay a 10% penalty. The SECURE Act eliminates this penalty for new parents.
Taxes Still Need to Be Paid
While you won’t have to pay the penalty, you will still have to pay taxes on the withdrawal. Whether you withdraw $5,000 or $10,000 (if both partners withdraw $5,000), that money will appear as income on your tax form, and you will have to pay taxes on it.
Why You Should Carefully Consider Using this Option
While knowing how new parents can tap their retirement savings penalty free when you’ve had a baby is a nice option, you should try to avoid tapping your retirement for a number of reasons.
You Lose Compounding Interest
If you take $5,000 out of your retirement income, you lose the compounding interest that money was making for you. Every month, that money was generating income, and now, it won’t be.
May Start a Dangerous Precedence
Retirement funds are for retirement. Once you start pulling from your retirement, you may start doing that regularly. It’s very easy to start thinking of your retirement account as a de facto emergency fund and pull money from it whenever you have an unexpected expense. If you get into this pattern, you can easily decimate your retirement account.
I have a friend whose child had emotional issues, so my friend was desperate to help her child. She sent him to residential treatment facilities and wilderness camps to try to help her son get his behavior under control. Her insurance wouldn’t pay for these treatments, so she relied heavily on pulling money from her retirement account. Now, her son is grown and still having emotional problems. She, meanwhile, has emptied her retirement account and is starting over, trying to build a new retirement fund at the age of 45. It’s not a good place to be.
Of course, you can take out the money, pay your taxes, and be done with it. However, if you want to make up for what you had to take out, there are ways to do so.
Pay It Back Within Two Months
Check with your financial advisor, but for many retirement accounts, if you withdraw money from your retirement account and can return that money back to the account within two months, it’s as if you never withdrew the money. You won’t have to pay taxes on it. Think of it as a short-term, two-month loan.
This can be an excellent way to get a short-term loan, IF you can pay it back quickly. This may help you if you want to take a one-month, unpaid paternity leave and know you can get the money back into your retirement fund the next month.
Pay It Back Overtime
Another option is to gradually pay it back over time. Under this option, you still have to pay taxes on your distribution. However, by paying back the money to your retirement account, you gain back the power of compounding interest on the money you originally withdrew. With this strategy, your retirement account will be healthier and more robust than if you simply withdrew the money and never paid it back.
Other Times You Can Withdraw from Your Retirement Account Penalty Free
Beyond how new parents can tap their retirement savings penalty-free within a year of having a new baby or adopting a child, there are other times people can tap their retirement accounts penalty free. However, before considering taking money out for any other reason besides having or adopting a child, consult your financial advisor. Some rules differ depending on the type of retirement account you have (IRA or 401K).
You can tap your retirement account penalty free for related higher education expenses such as tuition, fees, supplies and books. This money can be used for your own higher education, or for your spouse or children.
First-Time Home Purchase
If you’re a first-time home buyer, you can take $10,000 out penalty free to use as the down payment on your new home. If your spouse has his or her own retirement account, he or she can also withdraw $10,000, giving you up to $20,000 toward your new home.
Some years you may incur significant medical expenses in a year (i.e. greater than 10% of your annual income). During those years, you can take money out of your IRA to pay for medical bills without incurring a penalty.
The SECURE Act gives new parents flexibility when it comes to their retirement withdrawals. However, keep in mind, whether you withdraw money for a new child or for any of the other reasons you can withdraw money penalty-free, you still will have to pay taxes. You’ll also be losing the power of compounding interest on that money, which may be the biggest hit of all.