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According to a recent Bankrate survey, in 2010 nearly one out of every five Americans raided their retirement money to cover urgent financial needs. Even more alarmingly, around 17% of people with full-time jobs tapped their retirement plans early. That combination is a tragedy on many levels.
For one thing, it's a sign that times are still tough for far too many people. For another, it suggests that a lot of folks have been living paycheck-to-paycheck, with little saved aside from their invested retirement accounts. And to make an already bad situation worse, tapping retirement money early often leads to penalties on top of ordinary income taxes on the withdrawn amounts.
But perhaps the biggest long-term risk from those raids is the risk of never being able to retire, driven by the loss of compounding from the money that's no longer working on their behalf.
Stem the bleeding
While little can likely be done for those who've exhausted all other options and desperately need the money now, there are ways to minimize the impact of such a move. For one, there are legitimate exceptions to the tax penalty on early withdrawals. Those include situations like:
- Substantially equal periodic payments,
- Permanent disability or death of an account holder,
- Excessive medical expenses or health insurance premiums if unemployed, or
- Education or some first-time home buying expenses.
While not ideal by any stretch, if you find yourself in a situation where your only option is to tap your retirement accounts early, check to see if you can qualify to avoid the penalties. Because if you do qualify, that's less of your precious retirement money lost without doing you any good.
Take the income, leave the principal
Another point to consider if you're in that situation is whether you really need to empty your retirement account or just supplement your cash flow for awhile. If what you really need is supplemental cash flow, then you might be better off thinking like a regular retiree would. By shifting your retirement portfolio to income producing assets with decent yields (like preferred stocks), you may be able to get sufficient cash flow while still staying invested.
If a 6% to 7% draw on your retirement money is enough to close your cash flow gap, even after accounting for the withdrawal taxes and penalties, you may want to consider preferred shares. By just pulling out the income from the preferred shares, you get the benefits of staying invested and keeping the bulk of your money in your tax-deferred retirement account. That way, as your financial condition improves, you can stop the withdrawals and keep your nest egg intact.
To find good preferred candidates, I screened for preferred stock issuers with investment-grade debt ratings, preferred stock yields of more than 6%, and prices below the $25 level above which many preferred shares can be called or redeemed. The table below shows the handful of companies that met those criteria:
Preferred Stock Ticker
Preferred Stock Recent Yield
Yield on Common Stock
S&P Credit Rating
|Aegon (NYSE: AEG )||AEF||7.3%||0%||A-|
|CommonWealth REIT (NYSE: CWH )||CWH-PD||7.3%||7.4%||BBB|
|Duke Realty (NYSE: DRE )||DRE-PK||6.9%||4.5%||BBB-|
|HSBC Finance (NYSE: HBC )||HFC-PB||6.7%||3.3%||AA-|
|ING Groep (NYSE: ING )||INZ||7.5%||0%||A|
|Public Storage (NYSE: PSA )||PSAD||6.3%||2.8%||A|
|Telephone & Data Systems (NYSE: TDS )||TDI||6.8%||1.4%||BBB-|
The key advantages of preferred stock are:
- You can generally get higher yields than on the debt of similarly rated companies.
- By definition, preferred shares get preferential dividend treatment over the common stock. In other words, common dividends generally must get cut before preferred ones. In addition, in most (but not all) cases, preferred dividend yields are higher than yields on common shares.
Of course, they have risks, too:
- Preferred shares are often redeemable and/or callable. If interest rates drop or the preferred shares mature, the company may have the right to call back the shares at a predetermined price.
- On the flip side, if interest rates rise, the price of the preferred shares may drop, since their dividends are often fixed payment amounts.
- Preferred shares are junior to bonds in the corporate pecking order. If the company runs into financial trouble, the preferred dividend may be cut, and in a bankruptcy, there may not be enough cash left to pay off the preferred shareholders' claims.
Protect yourself sooner
Ultimately, though, your best option to avoid having to raid your retirement account early in the first place. Your best shot at that is to plan for the potentiality now, to shore up the rest of your financial picture in advance of any need. You can do things like:
- Pay off high-interest debts.
- Build an emergency fund with at least three to six months of living expenses.
- Cut back now on costs that are not strictly necessary.
- Decide what else you'd be willing to live without if worst came to worst.
By minimizing your cash outlays and maximizing your savings buffer, you'll reduce your chances of needing to access your retirement money early. And even if you still have to tap that nest egg early, getting prepared now can save you lots of headaches and costs later.
However you ready yourself for a financial emergency, remember that the way you react to it can have repercussions that last long beyond the emergency itself. The more efficiently you tap your money when you need it, the better off you'll ultimately be.