Find Alternative Funds Before Early Retirement Account Withdrawals
If you are in need of money, your retirement account probably looks quite tempting. It is most likely the largest liquid asset that you have. However, you should search for another source of funds before tapping your retirement account early.
The are a few reasons behind this; let’s start with taxes. The IRS imposes an early withdrawal penalty of 10% for any withdrawal from a retirement fund under the age of 59 ½. This penalty combined with normal income taxes (US, state, and local) could add up to about 35% in taxes on an early withdrawal, possibly more depending on other income! This is a huge amount of money forfeited instead of possibly $0 tax in retirement. Wait, $0 in retirement?! Yes, some people can withdraw from retirement funds and pay nothing in taxes if their other earnings are below a certain amount. Even if you end up with a tax bill greater than zero, it should be a lot less than 35%!
Picture holding onto that money in your retirement account instead of taking an early withdraw. When you do withdraw funds during retirement, you are paying less taxes on MORE money! This is due to compounding interest and it’s vital to retirement savings. Let’s take the example of pulling out $10,000 at age 30 to pay off debt. You will end up with $6,500 net cash ($3,500 due in taxes). If you leave in the $10,000 it could grow to over $100,000 by age 60. Say you put back the $10,000 at age 40; it might grow to $46,000 at 60. You would need to contribute $22,000 instead of $10,000 to get back up to that $100,000, and remember, you only received $6,500 after taxes. As you can see, if you pull out your money, it will be very challenging to get back those lost earnings. Plus, in my experience, people are rarely able to contribute the lump sum back into the account as planned.
In periods of volatility, the market can go up and down quickly in short time, with the largest moves happening in a matter of days. You never know when the market will leap and you want to be in it for the big gains!
As seen, tapping your retirement funds should be an absolute last resort. Instead, I recommend:
Draw from emergency savings fund.
Decrease spending to free up cash.
Draw from a Roth account first if needed, only tapping contributions. This will result in a $0 tax bill but still diminishes future gains.
Take out a personal loan, home equity loan, or home equity line of credit. Be aware that by using your home as collateral, it could be foreclosed upon in default.
Use a 401(k) loan. This should be one of your last options as it could easily become a taxable event, and you’ll still lose out on potential market gains.
If you are in need of money, carefully evaluate all options. Consider talking to a professional to understand which might be best in your situation while keeping you financially prepared for a long retirement!
This blog is for general educational purposes and does not constitute financial, tax, or legal advice. Please contact our firm for specific advice applicable to your personal financial situation.