There are a lot of rules surrounding retirement saving telling you what you are and aren't supposed to do with your money. Do start saving early, don't rely too much on Social Security, do contribute as much as you can to your 401(k), etc.
There's one "don't," though, that is less obvious but just as important: Don't take money from your retirement fund before you retire. Withdrawing your money too early comes with a host of consequences and can potentially irreparably damage your retirement savings -- yet those risks don't stop more than half of Americans from doing it.
Why Americans are raiding their retirement funds
Approximately 52% of Americans have withdrawn money from their retirement savings before reaching retirement age, according to a survey from MagnifyMoney. The reasons vary, but nearly a quarter of those who have withdrawn from their retirement fund did so to help pay off debt. Another 17% needed cash for a down payment on a home, 11% pulled money to help with college tuition, and 9% used the cash for medical expenses.
It's understandable to want to raid your retirement fund when you need cash. After all, you likely have at least a couple decades left to save for retirement, whereas these other expenses are more immediate. What's the harm in pulling a few thousand dollars from your savings when you have so much time to pay it back?
In reality, even relatively small retirement fund withdrawals can significantly affect your savings. First, early withdrawals have an immediate effect on your bank account because you may owe a penalty. If you withdraw from your 401(k) or traditional IRA before age 59-1/2, you could owe a 10% fee on the amount you withdraw. Depending on how much you withdraw, that could be a serious chunk of change. In addition, you'll owe income taxes on that money, which also eats away at your cash.
Second, withdrawing too early can also have significant long-term effects on your retirement fund. Compound interest allows your savings to grow exponentially the longer they sit untouched in your retirement fund, so when you lower your balance by making a withdrawal, it has long-term consequences. Sometimes withdrawing even a couple thousand dollars can ultimately cost you 10 times that much down the road.
The damaging effects of early withdrawals
To see just how much these early withdrawals can affect your savings, let's look at a hypothetical example. Say you're 40 years old with $50,000 in your 401(k), and you withdraw $5,000. Let's also say you were saving $250 per month earning a 7% annual rate of return on your investments, and you continue saving at that rate even after you make your withdrawal.
First off, you'd immediately be hit with a 10% penalty for withdrawing before age 59-1/2, which in this case would be $500. But you could end up losing a lot more than just $500 over the long term. Here's what your total savings would look like over time if you had or had not withdrawn from your account:
|Age||Total Savings If You Did Not Withdraw From Your 401(k)||Total Savings If You Did Withdraw From Your 401(k)|
In other words, that $5,000 withdrawal can potentially cause you to miss out on nearly $40,000 in savings over a few decades. If you repeatedly withdraw money from your retirement fund over the years, it could cost you even more.
Is it ever OK to withdraw from your retirement fund?
If you're in a dire financial situation -- whether you're drowning in debt or slapped with an expensive unexpected cost -- withdrawing from your retirement fund may seem like your only option. But pulling money from your savings should be your very last resort, and it's a better idea to consider other options first.
For example, if you're saddled with loads of debt and paying high interest rates, try to get creative when paying it down. If you're burdened with credit card debt, try opening a balance transfer card to take advantage of the low introductory rate -- which will help you pay off your debt faster. Or if you're buried in student loan debt, consider refinancing your loans for a lower interest rate.
If you truly have no other options, consider taking a loan from your retirement account rather than withdrawing. You can borrow up to $50,000 or 50% of your total balance (whichever is the lesser amount), and you generally have to pay the money back within 5 years with interest (which just goes back into your account). While you still stand to lose some money in potential earnings over the years, it likely won't be as drastic as if you were to withdraw it completely. Keep in mind that this option should only be used as a last resort, and it's best to avoid touching your retirement money if at all possible.
Withdrawing money from your retirement fund may not seem all that bad on the surface, but the long-term consequences can be significant. Before you take money from your savings to put toward other financial needs, consider whether you have any other options. If you leave your retirement fund alone, you'll be in much better financial shape come retirement age.