Money you put in your retirement accounts is supposed to stay there until you're ready to exit the workforce, but it doesn't always work out that way. When you're pressed for cash, your retirement account can look like a piggy bank just waiting to be cracked open -- and many people give in to the temptation.
A recent Transamerica survey found that 28% of Americans were guilty of taking a loan or early withdrawal from a retirement account. The most commonly cited reasons for doing so were paying off debt and covering unplanned expenses. Borrowing money from your retirement accounts might be the wiser choice if your only alternatives are to take on more debt or fall behind on your living expenses, but it's not consequence free, even if you pay back every dime you borrowed. Here's a closer look at why, along with some steps you can take to avoid borrowing from your retirement accounts.
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The problem with taking early withdrawals from your retirement account
Early withdrawals are considered any retirement plan withdrawal made before you turn 59 1/2. If you withdraw money from a tax-deferred retirement account before this age, the government will slap you with a 10% early withdrawal penalty on top of income tax on the withdrawn amount. You can avoid the early withdrawal penalty if you meet certain criteria, like buying your first home, using the money for higher education, or incurring medical expenses that exceed 10% of your adjusted gross income (AGI).
You won't owe income tax or a 10% early withdrawal penalty on Roth account contributions that you withdraw before 59 1/2 because you've already paid taxes on that money. But if you withdraw any Roth account earnings before you've turned 59 1/2 and have had the account for at least five years, you can expect to pay a 10% penalty on those.
While paying extra taxes and penalties is no fun, it's not the biggest drawback to taking early withdrawals. When you take that money out of your retirement account, you're not just taking away the few thousand dollars you need right now; you're giving up the potential tens or even hundreds of thousands of dollars that money could have turned into if you'd left it in your retirement account for the next few years or decades.
You're also putting an even greater savings burden on yourself in your later years, because your later contributions don't have as much time to grow as your earlier ones, so you must set aside even more of your own money each month in order to end up with enough by the time you're ready to retire.
To put this in perspective, let's consider someone with $30,000 in their retirement account who borrows $10,000 for a first-home purchase. That leaves them with $20,000. Over 30 years, that $20,000 could grow into more than $152,000 with a 7% annual rate of return. That doesn't sound that bad until you consider that if that person hadn't borrowed the $10,000 from their retirement account, their initial $30,000 could have grown into more than $228,000 over the same time period with the same rate of return. That's a difference of about $76,000, which they will have to make up by increasing their monthly contributions in the future.
Borrowing from your retirement accounts isn't much better
You might think that taking out a 401(k) loan isn't as bad as taking an early withdrawal because you'll pay back the money with interest. And you're correct in saying it's not as bad. But it's still costing you. For one, if you fail to pay back what you borrow, it's considered an early withdrawal, and you'll pay all the applicable taxes and penalties outlined above. Plus the interest rate you pay back on your loan might not be as high as the rate of return that your savings could have earned if you'd left them alone.
Consider the same $10,000 scenario as above but this time taken as a 401(k) loan with a 6% interest rate and a 10-year loan term. You'd end up paying back the initial $10,000 you borrowed plus $3,322 in interest for a total of $13,322. But if you'd left the $10,000 in your account and it earned a 7% annual rate of return over that time, it would've been worth $14,203 by the end of that decade. So by taking the loan, you still lost $881.
Alternatives to taking money from your retirement accounts
As I mentioned above, the two most common reasons for taking money from retirement accounts were to pay down debt and to cover unexpected financial emergencies. But there are other ways to handle both of those things. If you have debt, consider refinancing your loan to get a more affordable monthly payment. For credit card debt, try taking out a personal loan or transferring your balance to a card with a 0% introductory APR. Consult with a financial advisor if you're unsure how to best tackle your debt problems.
Build an emergency fund to cover unexpected costs. It should contain at least three months of living expenses, six months if you can manage it. Make sure it contains at least enough to cover your insurance deductibles in case you need to file a claim. Draw upon this money instead of your retirement savings when an unexpected expense arises. Replenish your fund after every time you use it, and reevaluate it as your family size and lifestyle change. You might decide to increase the size of your emergency fund.
If you have no choice but to borrow money from your retirement account, make sure you understand the potential costs of doing so. You'll also need to reevaluate your retirement plan to figure out how much more you will need to save each month in the future to make up for the amount that you're withdrawing now. You might need to make some changes to your budget, like cutting discretionary spending, to free up more cash for retirement savings, but it's better to do this than to run out of cash in retirement when it's too late to do anything about it.
