The biggest effect that most investors will have on their long-term wealth is from saving. Investing is important, but you can't invest if you don't save. And if you don't save enough, even the best investing performance probably won't save your retirement.
That's why it's so important to take advantage of 401(k) plans and IRAs. These tools make saving easy and come with important tax benefits. But there's a costly mistake you need to avoid, or the IRS will come calling in a not-so-good way. Here's what you need to know.
Tax-advantaged retirement accounts are powerful
You could save for retirement in a taxable account, like a typical brokerage account or mutual fund account. That's fine, and, frankly, you should probably be doing so. But these aren't the only options you have. You can also save money in tax-advantaged savings accounts like a 401(k), if your company offers one, or an IRA, which you open on your own. The tax advantage these accounts offer are a powerful wealth-building tool.
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When you put cash into a 401(k) or IRA (which stands for individual retirement account), you are doing so before taxes. So the savings avoid current taxation, effectively lowering your income. While those funds are in the tax-advantaged account, you don't pay taxes on any of the transactions that take place, including events that lead to capital gains, dividends, or interest income. This increases the compounding effect, allowing your money to grow more quickly.
Of course, there are some downsides. You don't get to take advantage of capital losses, which can be used to offset gains in a taxable account. You also have to pay taxes on withdrawals from 401(k) and IRAs as if the cash were earned income. That may subject withdrawals to higher taxes than you might expect.
Don't make this costly withdrawal mistake
There's one other very big drawback to 401(k) and IRA accounts. Once you put money into the account, you can't take it out until you reach "retirement age." There are some nuances to this rule for special situations, like the birth of a child or buying a home. But, as a general rule, if you take money out before age 59 1/2, which is known as an early withdrawal, you can open yourself up to a penalty... and it's a doozy.
The first thing here is that you will pay income tax on the money you withdraw early. That's no different than if you withdrew the money after age 59 1/2. But in addition to the normal taxes you owe, you will also be hit with a 10% penalty tax. That's a very big number and could wipe out years of gains.
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Key Data Points
This is where the power of compounding comes into play. The average return on the S&P 500 index over the last 50 years or so was around 10% a year. So, arguably, the 10% penalty tax is "only" wiping out a single year of performance if you own an S&P 500 index fund like the Vanguard S&P 500 ETF (VOO +0.82%). The problem with this logic is that market performance isn't distributed smoothly over time. The market swings between good years and bad years. So a bear market could make a premature withdrawal feel even worse.
But that's still not the big story. Compounding is basically the benefit you get when your earnings start earning. This benefit builds up over time. It's kind of like a hockey stick, with the real rise in value taking place toward the end of the time period you are looking at. Think about this sequence of doubling: 1+1=2, 2+2=4, 4+4=8, 8+8=16, 16+16=32. The first three doubles were big, but the last two were much bigger on an absolute basis. If you make a premature withdrawal after a long period of investment, the 10% penalty tax would come at the end of the compounding sequence. It could hurt much more than you expect.
Follow the rules or face the consequences
To be fair, the withdrawal rules for 401(k) plans and IRAs can be a bit complex, and the premature withdrawal rules are particularly difficult to understand. But you need to understand them if you're looking to make a premature withdrawal, or you could be facing a very large tax bill. In the end, you should do your best to avoid touching 401(k) and IRA money until you are 59 1/2. But if you do have to get at that money, take the time to understand the IRS rules before you withdraw the cash.
