Are you in the process of a big, expensive cross-country move? Maybe you are considering buying a bigger house and need money for a down payment. Or perhaps you had an emergency and don’t have enough cash to cover it.
Withdrawing some of your retirement savings may seem like the best, or only, option to help you afford any of these scenarios. But what you may not be aware of are the huge financial ramifications if you withdraw retirement savings early.
If you are not over 59.5 years old when you decide to withdraw retirement savings early from your IRA or other qualified retirement savings account, you will have to pay taxes on your withdrawals and an additional 10% penalty.
Ten percent may not sound like a lot, but if you are withdrawing $20,000 that penalty alone will cost you $2,000 (without considering taxes that you’ll also have to pay on your withdrawal).
This rule still applies if you decide to withdraw retirement savings early because you left your current employer. In this case, you should consider leaving your retirement savings where they are, or rolling them into a different IRS approved retirement savings account, like an IRA.
Along with the tax ramifications if you withdraw retirement savings early, you also need to consider the opportunity cost of taking your money out of your retirement savings. Withdrawing money from your account for any reason will result in your interest earnings being less and compounded over time. This could add up to a huge opportunity cost.
Exceptions to the Rule
As with anything, there are exceptions to these rules of when to never withdraw retirement savings early. The IRS does allow withdrawals from qualified retirement savings accounts without these consequences if you can prove a hardship. The following things usually qualify for a hardship withdrawal without consequences:
- To prevent foreclosure on your primary residence
- To purchase a primary residence
- To pay for repairs to your primary residence
- To pay medical bills for your family
- To pay funeral expenses
- To pay for higher education for yourself or your family
Another option to consider is a loan from your retirement account. This option allows you to access the money for one of these reasons without having to pay huge tax penalities.
What if You Stop Contributing?
Sometimes instead of deciding to withdraw retirement savings early, people stop contributing to their account to save for another purchase. This decision will still cost you more in taxes, as it makes your taxable income higher if you investing pre-tax dollars, and it will also come with an opportunity cost of its own.
If you have an employer-sponsored 401(k) retirement plan, you might be missing out on some employer contributions if you stop investing your own money into the account. You will also lose out on the compounding interest of your contributions and your employer’s contributions too.
Other Options to Withdraw Retirement Savings Early
Perhaps instead of choosing to withdraw retirement funds early or stopping contributions to save up or pay for some of the scenarios we discussed earlier, you could instead find other things to cut from your budget to put in your emergency fund, or to save up for a down payment on a new home.
Cutting things now to help pay for things in the future may not sound like fun, but your future self will definitely thank you for it.