Retirement accounts give you some pretty awesome tax breaks, but they come with a catch. When you put the money in your account, you're agreeing that you won't take it out again until you're at least 59 1/2. If you withdraw funds from your retirement accounts early, you usually pay a 10% early withdrawal penalty, plus income tax if the money came from a traditional IRA or 401(k).
There are exceptions to the penalty for large medical bills, first-home purchases, and qualifying educational expenses, among other things. But just because the government isn't throwing salt in the wound doesn't mean these withdrawals don't hurt you over the long term.
Early withdrawals impede the growth of your retirement savings, but that hasn't stopped a lot of people from doing it anyway. Approximately 46% of 40-somethings reported withdrawing money from their retirement accounts, according to a recent T.D. Ameritrade survey. Let's take a closer look at why that's a problem and what you can do instead if you're in need of some quick cash.
The real costs of an early retirement account withdrawal
Let's say you need $5,000 to help you make a down payment on your first home. You don't want to wait to save up, so you take the money from your IRA. A first-home purchase is a qualifying exemption to the 10% early withdrawal penalty, so you won't have to worry about that, though you will have to pay taxes on that $5,000 unless it comes from a Roth IRA. Still, it doesn't seem that bad, right?
What most people fail to consider is that you're not just giving up $5,000. If you'd left that $5,000 in your retirement account for another 10 years and it earned a 7% average annual rate of return, it would be worth about $9,836. If you left it alone for 20 years and it earned the same rate of return, it would be worth $19,348. And if you left it alone for 30 years, it would be worth $38,061. In addition to the $5,000, you're giving up all of the investment earnings you could've earned on that sum if you'd left it where it was. Now, you'll have to save more per month going forward in order to have enough to achieve your retirement goals.
Some 401(k)s allow loans, where you withdraw money from your account temporarily but pay it back with interest. This may not seem as bad as an early withdrawal -- and it's not -- but it doesn't mean you're not still costing yourself money.
Consider the same $5,000 scenario we described above. You borrow the money through a 401(k) loan that has a five-year repayment term and a 6% interest rate. You'd pay back the initial $5,000 plus another $800 in interest. That's not bad, but if you left the money alone and earned a 7% average annual interest rate, you'd end up with $168 more. It seems like a small difference, but again, you're forgetting about the foregone investment return on that $168, which could add up to a lot more over a few years or decades.
How to get the money you need without tapping your retirement savings
There might be times when you have no other choice but to tap your retirement savings or risk going into debt. In that case, it might be the right move. But you can avoid this tough choice by planning and saving for large expenses now.
Everyone should have an emergency fund containing enough money to cover at least three months of living expenses. Six months is even better. You can use this money to cover emergency costs, like an unplanned medical bill or your living expenses following a job loss. This way, you won't have to dip into your retirement savings.
For other goals you can plan for, like a new home or car, figure out how much you need and decide how much you can afford to put toward this goal each month. If you have a deadline, divide the amount you need to save by the number of months you have to figure out what you must save each month.
Tapping your retirement savings is better than letting yourself fall into debt and losing your current financial security. But it's a risky trade-off because by withdrawing your money now, you could be jeopardizing your future financial security. You can avoid this by building up an emergency fund today and creating a plan for your long-term goals using your extra money each month instead of your retirement savings.