I’ll be the first to admit that life has a way of throwing curveballs at you when you’re seemingly least prepared for them. According to the Annual Transamerica Retirement Survey, 27% of people with retirement accounts had to make early withdrawals. Although it may be the last and only option, early withdrawals from your retirement accounts are costly and should be avoided. Here’s why.
Early withdrawals are not cheap
Retirement accounts are designed for exactly that: retirement. Part of the reason you get tax breaks with retirement accounts is because you agree to keep the money in the account until you reach retirement age. Otherwise, it would be too easy for people to get the tax break and then use the money as they would if it were in a regular savings or brokerage account.
Imagine if you could contribute to your 401(k), reduce your taxable income for the year, then withdraw the funds whenever you want. If you know the IRS, you know it’s too good to be true.
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The magic age to remember is 59 1/2. If you withdraw from a retirement account before age 59.5, you will likely face a 10% early withdrawal penalty. If you make an early withdrawal from a 401(k) or traditional IRA, you will not only have to pay the 10% penalty, but also income tax on any amount withdrawn. You will also face the 10% penalty with a Roth IRA, but only your earnings are taxed. Depending on your tax bracket and the amount you withdraw, you could lose a large portion of the proceeds.
If you’re in the 24% tax bracket, for example, an early withdrawal from your 401(k) could mean that more than a third of the total amount goes to taxes and fines. Imagine if you withdrew $30,000 from your 401(k) – between the $3,000 penalty and $7,200 in taxes, you would only receive $19,800.
There are a few exceptions to the 10% early withdrawal penalty, including permanent disability, active military service, and unreimbursed medical expenses that exceed 10% of your adjusted gross income. If you really need to get money out of your 401(k) but don’t qualify for a hardship exception, you also have the option of taking out a loan on your plan. The maximum you can borrow on your 401(k) is the lesser of $50,000 or 50% of your vested amount, and you’ll typically have five years to repay with interest.
Think about future value
Not only can early withdrawals be costly in the present, but you also need to consider the potentially lost future value. At average annual returns of 7%, the $30,000 mentioned above could accumulate to over $116,000 in 20 years. This is a significant sum that could be essential to someone’s retirement income. If you follow the 80% rule – which says you should aim to have 80% of your pre-retirement income in retirement – $116,000 could be two to three years of expenses.
An emergency fund should be the top priority
Before you start investing, the first thing you need to prioritize is building an emergency fund. If you are single, you should try to save at least three months of expenses. But if you have a family, consider saving enough to cover six months. However, with the current economic uncertainty and looming recession fears, you may want to put some extra aside just in case.
It’s easy to think that you don’t have to prioritize your emergency fund and that you can build it up slowly but surely while you focus on investing, but the problem with emergencies is that they usually occur at the worst times. You don’t want to be stuck in a situation where you’re putting down a lot of money in retirement, an emergency arises, and you’re forced into debt or face penalties to access your savings. Having an emergency fund can be a real life (and wallet) saver.
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