Investing enough for retirement is a challenge. Unfortunately some people end up making it harder by making a costly error.
It's helpful to understand the risks of this common mistake so you can avoid it if possible. By doing so, you'll maximize the chances of ending up with the funds you need to enjoy your later years.
Will you put your retirement security in jeopardy by making this financial move?
The big financial mistake many Americans are making when it comes to retirement savings involves raiding their investment accounts.
According to a recent study from the TransAmerica Center for Retirement Studies, 34% of workers have accessed their retirement funds early. They've done this by taking a 401(k) loan, an early withdrawal, or a hardship withdrawal. The study showed that 25% borrowed money from their retirement accounts and 25% took either an early withdrawal or a hardship withdrawal. The numbers add up to more than 34% because many workers took loans and made withdrawals.
Early withdrawals involve taking money out of a tax-advantaged retirement account without falling into one of the exceptions allowed by law for penalty-free early withdrawals and thus incurring a 10% penalty. Hardship withdrawals are taken before retirement age but for an allowable reason, so the 10% penalty is avoided. And loans involve borrowing against a 401(k) plan or similar account that allows loans and paying the money back to yourself.
Full-time workers are actually more likely to have taken money from retirement accounts than part-time workers, with 36% of people who are working full-time indicating they'd dipped into their savings compared with just 22% of part-time workers. This could be explained by the fact that workplace accounts such as 401(k)s generally allow loans, while individual accounts like IRAs don't.
Why is taking money out of a retirement account such a big mistake?
Withdrawing money from a retirement plan early may seem like an OK financial choice -- especially if you're borrowing from yourself with the intent to pay it back. After all, the money is there. And if you face a short-term hardship, you may think it's a better bet to use it than to borrow to meet your current needs.
But there are a few reasons early withdrawals can be a big problem.
First and foremost, if you're getting hit with penalties for an early withdrawal, you're giving away a huge chunk of your money for nothing. You also have to pay taxes at your ordinary income tax rate on the withdrawn funds. Because of the taxes and penalty, you could end up being able to use just a fraction of the amount you withdrew. If you took out $10,000, faced a 10% penalty and were in the 22% tax bracket, you could end up with less than $7,000 in usable funds after taxes.
You're also missing out on the returns you'd have earned -- and this can have a huge cost over time. If you take out $10,000 30 years before retirement and don't put it back, you aren't shrinking your final account balance by $10,000. You could end up with as much as $101,985 less by losing the returns that $10,000 would have earned over three decades (assuming an 8% average annual return).
If you take out a loan instead of a withdrawal, you avoid penalties and the loss of decades of returns -- in theory, as long as you put the money back. But there's a chance you won't end up getting the funds back into your account. The interest you pay yourself could also be well below the returns you'd have earned during the duration of the loan. And your account balance could end up a lot smaller if you happen to borrow at an inopportune time and miss out on some big stock market rallies.
Ultimately, once you put your money into a retirement account, it's best to do everything you can to leave it invested if you want to maximize the chances of ending up with the nest egg you need. So unless you have no other choices, avoid making the mistake of raiding your retirement accounts before you're ready to rely on them as a senior.