Dubai: You may have heard often that it’s highly advisable that you avoid taking retirement account withdrawals, before the agreed-upon lock-up period. But when faced with no other choice but to, knowing how much it actually costs you, will help you understand the severity of doing do.
When money is tight and you're faced with an unexpected expense, it may be tempting to pull the cash from your retirement fund. However, even relatively small withdrawals can make it much more challenging to reach your, let’s say, a goal of Dh1 million.
Say, for instance, you have Dh100,000 saved in your retirement fund and you're earning an 8 per cent annual rate of return on your investments. Let's also say you're considering making a one-time Dh5,000 withdrawal.
Here's how much you'd have saved over time, assuming in either scenario you're not making any additional contributions.
In this particular case study, that single Dh5,000 withdrawal could result in more than Dh50,000 in missed potential earnings. If you were to make repeated withdrawals over the years, you could miss out on even more.
COVID-19 and withdrawals from retirement plans
The COVID-19 pandemic has forced many to almost exhaust their savings and emergency funds, research shows, while also leaving many questioning whether they will need to dip into retirement savings to cover current expenses.
Under typical circumstances, one who withdraws funds from a traditional retirement account before the age of 60 is subject to an additional tax for early withdrawal, especially if your retirement is located in a country where your income is taxed – like your home country, if you are a UAE-based expatriate.
If you take a financial hardship-triggered withdrawal from your retirement plan, you permanently reduce your retirement savings balance. In other words, you are not allowed to put the money withdrawn back in the retirement account after the hardship has passed and you must pay tax on it.
What if I invest the money I withdraw from my retirement fund, or borrow against it?
Many, especially during the current pandemic, have been considering selling or borrowing against their retirement accounts to make new investments in market-linked securities or assets.
If you are thinking about withdrawing or borrowing money from your retirement plan for the specific purpose of investing – especially if at the urging of an advertiser/promoter or on the advice of an investment professional – first consider these factors:
You may pay high fees to the promoter: The promoter may charge you a fee or commission for the investments they are offering. In addition, the promoter or a person or company related to the promoter may impose ongoing costs and fees on the investment.
High initial and ongoing fees for retirement investments are a red flag. Ask if there are any up front or ongoing fees or commissions, when presented with any such retirement-linked investment offers. In other words, ask how much of your money is working for you and how much is going to others.
It can be difficult or costly to sell the promoted investment: The promoted investments may have fees for early withdrawals or may otherwise make access to your savings costly or difficult. Ask if there are any fees or restrictions on early withdrawal or any sale.
Selling at low prices locks in your losses: Taking money from your retirement account usually requires you to sell some of the investments in your account – and you might not be able to choose which ones.
In many plans, the money is taken in equal portions from each of your different investments. For example, if you have money in four mutual funds, 25 per cent of the loan total comes from each of the funds. If you liquidate investments when the market is down or prices are otherwise low, you will lock in losses.
You may lose out on compounding: Withdrawing money from a retirement account, even without a penalty, can have significant impacts on your future retirement savings because you lose out on the compound growth from any funds you withdraw – like in the above mentioned case study.
You may significantly increase your risk: When you buy securities with money from a retirement fund, you are investing with borrowed funds. While this can increase your buying power, it also increases your exposure to market risk at the very same time you are hoping your investment will increase in value.
If the investment sours, including as a result of high fees and costs, you not only stand to lose the amount you invest, but you also might have difficulty repaying the funds withdrawn or loaned within the respective three- or five-year time periods.
You further compound your risk if you put your money in higher-risk and higher-fee investments than those available in your retirement plan.
What to consider before withdrawing money from your locked-in funds
The feasibility of withdrawing money from your retirement account will depend on the specifics of your situation. Some of the factors include:
Your age when the distribution was made: Early distribution penalties apply when you withdraw money from a retirement plan before you reach age 60. Although the amount varies with each country and account, you are definitely levied a charge.
What type of retirement plan you have: If your retirement is located in a country where your income is taxed, then keep in mind that contributions to some retirement plans are made tax-free, at least until they're withdrawn.
Once the money is withdrawn, the income tax comes due on the amount withdrawn. These income taxes are in addition to any early distribution penalties you face.
How much you plan to withdraw: The penalty is a percentage, so the more you withdraw, the more penalty you could pay.
What the money will be used for: As each contract terms vary, some purchases may not trigger a penalty tax.
For instance, in several cases, qualified first-time homebuyers may not face a penalty if they withdraw money from the retirement fund to purchase the home. Certain medical expenses may also qualify. However, expenses like utility bills won't qualify for an exemption.
Alternatives to pulling money from retirement accounts
Many retirement plans offer loans to employees. This is a unique feature of these employer-sponsored plans, which isn't currently available for UAE expatriate residents.
However, you might also consider shopping around for a lower interest rate personal loan, trying to earn extra income with a part-time job, or creating a budget to handle your new financial situation.
Taking a separate personal low-interest, low-tenure loan can help you meet short-term financial hardships while avoiding the hefty tax and penalties associated with outright retirement fund withdrawals.
GCC nationals employed in the UAE are entitled for pension in accordance with the schemes established in their home countries. Expatriate workers are not entitled to pension but are entitled to end-of-service benefits also known as gratuity or severance pay.
Verdict: Know the hefty price you will pay for withdrawing from your retirement account
As illustrated in the above analysis, if you were saving towards a million dirhams, withdrawing even Dh5,000 from your retirement fund, can cost you Dh50,000 by the end of the lock-up period.
Always do your research before making any investment decision, including a decision to withdraw or borrow money from your retirement account for the purpose of investing in securities.
Know who you are dealing with, be wary of fraudulent investment scams, and be sure you understand how the investment fits into your overall financial plan.
