The High Cost of Raiding Your 401(k)
401(k)s are often the largest asset people have for retirement. We save year after year, paycheck after paycheck, with the goal to have a comfortable retirement.
However, there are times when we may be tempted to dip into our retirement savings before we reach retirement age.
While it may seem like an easy way out of a financial jam, taking money from your 401(k) may have serious long-term financial consequences.
Keep reading for the downsides to raiding your 401(k).
#1 Missing Out on Compound Returns
One of the key advantages of a 401(k) is the power of compound returns.
When you contribute to a 401(k), your money earns interest, and that interest compounds over time – meaning you earn returns on your returns.
This may lead to significant growth over time. The longer your money is invested, the more it can grow.
Should you raid your 401(k) early – whether it’s a 401(k) loan or withdrawal – you risk missing out on that compounding effect and your losing out on the potential growth. This can have a significant impact on your retirement savings over time.
#2 Taxes and Penalties
In most cases, if you withdraw money from a retirement account before you reach 59½, you’ll face both taxes and penalties.
The IRS requires automatic withholding of 20% of a 401(k) early withdrawal for taxes if you are under age 59½ – and it’s considered ordinary income. This means you might be pushed into the next tax bracket if you’re not careful.
Along with the withholding taxes, the IRS will also hit you with a 10% penalty on all funds withdrawn when you file your tax return – again, if you’re under the age of 59½.
These taxes and penalties can significantly reduce the amount of money you need to withdraw, making it an even less attractive option.
#3 Harder to Catch Up
Retirement savings is a long-term game, and every dollar counts. If you raid your 401(k) now, you may find it difficult to catch up later.
If you withdraw money from your account, you’ll have to work that much harder to make up the difference later on, which may be difficult or even impossible depending on your age and financial situation.
#4 Robbing Your Future Self
When you take money from your 401(k), you’re essentially borrowing from your future self.
While it may be tempting to use that money now, it’s important to remember that it’s earmarked for your retirement years.
Taking money out now means you’re essentially reducing the amount of money you’ll have available to live on in the future.
This can lead to significant financial stress later on, especially if you’re not able to make up the difference.
The Root of the Problem
If you’re struggling to make ends meet or facing unexpected expenses, taking money from your retirement may provide temporary relief, but it doesn’t address the root cause of the problem.
Raiding your 401(k) early may be a band-aid solution to a larger financial problem.
More than likely, it may be that you don’t have an emergency fund or more liquid investments to draw from.
If that’s the case, taking money from your 401(k) will only temporarily solve your problem. But should another financial emergency arise, you’ll be right back where you started.
Make a plan today to reduce expenses so you can stash cash for emergencies. If you need to, take on a side hustle to increase your income, and then use the additional funds to save more.
One final thought: Should you absolutely need to raid your 401(k), we recommend speaking with a tax professional, as well as a financial advisor before making a move.