If you're like most Americans, your retirement accounts could be your biggest asset. And if you have a financial emergency, the absence of available cash could make them look like a good option.
But tapping into these types of accounts could cost you big in the long run. Here's how.
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1. You'll owe taxes
When you save into a traditional 401(k) or IRA, you get the benefit of tax-deferred growth. For your 401k and an IRA, if you qualify, the amount that you contribute also gets deducted from your taxable income for the year.
So if you make $100,000 and contribute $15,000 to a 401(k), you only owe taxes on $85,000 of your income. The growth that you experience from stock market appreciation in these accounts is also tax-deferred. But you don't avoid paying taxes forever, and the time comes when Uncle Sam will collect his share. That happens when you start taking money from these accounts.
If you take it out when you're retired, your income tax bracket could be lower than when you were working and you'll save on taxes overall. But if you tap into this account early, you will owe these taxes now and could end up foregoing these tax savings.
The table below shows the difference in taxes you could pay based on a 30% marginal tax rate when you are working and a 20% rate once you've retired.
| $100,000 distribution | $200,000 distribution | $300,000 distribution | |
|---|---|---|---|
| 20% tax rate | $20,000 | $40,000 | $60,000 |
| 30% tax rate | $30,000 | $60,000 | $90,000 |
Calculations by author.
2. You may owe penalties
If you are over the age of 59 1/2, you will only owe taxes on your distributions. But if you are under this age, you will also owe a penalty of 10%. This means that if you are in a 30% tax bracket, for every dollar you take out of your accounts you owe 40 cents in taxes and penalties. That could eat away even more at your savings. The table below illustrates how much you'd need to take out in the form of a distribution to cover this.
| $10,000 distribution | $20,000 distribution | $30,000 distribution | |
|---|---|---|---|
| Taxes owed | $3,000 | $6,000 | $9,000 |
| Penalty owed | $1,000 | $2,000 | $3,000 |
| Total amount of withdrawal | $14,000 | $28,000 | $42,000 |
Calculations by author.
There are some scenarios where you won't owe a penalty on your distributions even if you are under 59 1/2. Certain events like the purchase of a first home, medical expenses, or qualified higher education expenses distributions from a 401k are exempt, but only up to a maximum. And you will still owe taxes on these distributions. There is also a distribution strategy called the rule of 55, where you take equal payments from your 401k or IRA penalty-free, but you will still owe taxes on these withdrawals as well.
3. It could make meeting retirement goals harder
When you save and invest your money, it could help you reach your retirement goals faster or with less money because you are benefiting from compound interest. The more money you have invested, the more dramatic this effect is, and if you take money from these accounts it is lessened.
Taking money from your accounts now may not seem like a big deal, but over time it can have a huge effect on how much your accounts grow. The chart below gives an example of how much less your money would accumulate over 20 years when reduced by different amounts. Historically you could've earned 8% with a portfolio of 40% stocks and 60% bonds, 9% with 60% stocks and 40% bonds, and 10% with 100% stocks.
| $200,000 | $150,000 | $100,000 | |
|---|---|---|---|
| 8% rate of return | $932,191 | $699,144 | $466,096 |
| 9% rate of return | $1,120,882 | $840,662 | $560,441 |
| 10% rate of return | $1,345,500 | $1,009,125 | $672,750 |
Calculations by author.
One of the best ways that you can avoid accessing these accounts early is by having an emergency fund. Most experts agree on having at least six months of your expenses set aside in case of an unexpected event. But depending on things like how stable your employment is, you may want more. It may also be a good idea to have a certain amount of money set aside for an unexpected expense, like the purchase of a new car or a major home repair.
Your retirement accounts will partially replace the income that you'll no longer have from working. And the quality of life that you will live could greatly depend on how much you can save. Making sure you don't sacrifice this long-term goal for short-term roadblocks could be a vital part of your success.
