If you have money set aside for retirement purposes, it’s generally best to keep it where it is and avoid using it. This is especially the case with retirement accounts, like 401(k)s or IRAs. Not only could early withdrawal result in hefty penalties, but using your savings could also delay your retirement by months or even years.
In a blog article on Dave Ramsey’s website, Ramsey discussed why you should never withdraw money from your retirement savings — even if it’s to pay off debt. Here are some of the biggest ramifications of early withdrawal and how they can affect you now and in the future, according to Ramsey.
Early Withdrawal Could Mean Penalties and Taxes
One of the biggest reasons why you should never borrow from your retirement accounts is that doing so will usually result in an early withdrawal penalty.
In general, retirement accounts are designed to be used only after you turn 59 ½ years old. If you withdraw money before that point, you’ll have around 60 days to transfer it to another eligible retirement account. If you don’t, you could be hit with penalties and taxes.
Say, for example, you take an early withdrawal from your 401(k). You’ll have to pay a 10% penalty on the amount you borrow. The withdrawal will also be subject to taxes. Depending on how much you take out, you could even be pushed into a higher tax bracket — meaning you’ll have to pay even more when you file taxes. When all is said and done, you could end up paying around 30% of the amount you withdraw, according to Dave Ramsey.
And if you have an IRA — that is, an individual retirement account — the situation isn’t much different. Early withdrawals may also be subject to a 10% penalty. With a traditional IRA, you might also need to pay state and federal income tax on the amount you withdraw.
401(k) Loans Are Expensive
If you’ve got a 401(k), you might be able to take out a 401(k) loan for emergencies. However, Ramsey recommended against this option.
When you take out a 401(k) loan, you’re essentially borrowing money from your future self — and your retirement. This reduces how much money you have in your account and limits the power of compounding interest.
Not only that, but if you fail to pay back the loan on time, you could be hit with a 10% penalty and income taxes. And if you lose your current job while you still have the loan, you might be required to pay it back in as little as 60 days.
Keep in mind that not all 401(k) retirement accounts are eligible for a 401(k) loan. You’ll need to check with your plan administrator or review your plan’s details to see if this is even an option.
It’s Not an Emergency Fund
An emergency fund is a set amount of money that’s meant for emergencies or unplanned expenses that you can’t cover with your regular income. This includes things like an unforeseen medical bill or sudden layoff at work.
As Ramsey pointed out, many people view their retirement savings as an extension of their emergency fund. The problem is that once you use your retirement funds, they’re gone, and you’ll have to work double-time to make up for the amount you took out.
Instead of using your retirement savings as an emergency fund, Ramsey suggested building a separate fund for unplanned expenses. Even if you can only save up $1,000, it’s a start, and you can go from there.
You’re Disrupting Compound Growth
When you withdraw money from your retirement accounts, like your IRA or 401(k), you’re essentially losing money that could have built upon itself through compound growth. Ramsey used the following example to illustrate this.
Say you take out $50,000 from your IRA to pay for your student loans. Chances are, you’ll have to pay $5,000 in an early withdrawal penalty. You might also be hit with up to $15,000 in taxes. That leaves only $30,000 for your student loan debt.
In contrast, say you instead left the $50,000 alone for 20 years — or until you’re at least 59 ½ years old. Depending on the yield, you could have over $445,000 in your fund. This is also assuming that you don’t add any money to your account after saving the initial $50,000.
Early Withdrawal Hurts Your Future Self
Aside from losing out on the power of compound interest, borrowing money from your retirement savings also means you have less money for your future retirement. This can also reduce your retirement income when the time comes.
Although you might think that you can simply put more money back into your retirement account to make up the difference, this can be tricky. As Ramsey pointed out, even if you have the money, you’re still limited to the account’s maximum annual contribution limits. In other words, you might not be able to ever truly make up for the amount you took out.
Certain Exceptions Could Be Problematic
It’s possible to avoid the 10% early withdrawal penalty in certain cases. For example, if you use your 401(k) or IRA to cover a specific medical expense that’s greater than 10% of your gross income, you might be able to avoid the penalty. If you adopt or have a child one year, you might also be able to avoid the penalty on the first $5,000 you withdraw.
While exceptions do exist, you could still end up being taxed on the amount you withdraw. And if you’re not careful, you could take out more money than you intended — thus, hurting your future retirement goals.
Hardship Withdrawals Can Be Tricky
A hardship withdrawal allows you to use money from your 401(k) retirement account to cover “immediate and heavy” financial needs. For example, if you need the money to pay for funeral costs or avoid eviction, you might qualify for this exception. You’ll only be able to withdraw the exact amount you need to cover these expenses, however.
The issue with hardship withdrawals is that you’ll need to read the fine print to make sure your reason truly qualifies. If it doesn’t, or if you lie to get money without a penalty, you could be facing jail time, fines, tax penalties or a loss of employment.
There are select situations where you can use your retirement savings to cover certain expenses. But in most cases, you’re probably better off leaving that money where it is so that it can grow unhindered and you don’t end up with any early withdrawal penalties or fees.
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