Withdrawing money from a retirement account early should be a last resort — basically, only in the case of a financial emergency in which you have no other option. But financial emergencies are not the main reason why folks dip into their retirement savings early.
Folks are much more likely to crack their nest eggs before retirement for a much more mundane reason, according to a recent GOBankingRates survey: to pay off debt or bills.
Close to 2,000 people were polled for the survey. Those who said they had withdrawn money from their retirement savings early were then asked the main reason for which they did so. Respondents could choose from five options:
- Pay off debt or bills: cited by 43.99 percent of survey respondents
- Pay for a financial emergency: 21.72 percent
- Pay for medical expenses or health care: 21.66 percent
- Purchase a home: 9.36 percent
- Pay for higher education: 3.27 percent
The survey basically posed this as a multiple-choice question, so it’s possible there are other reasons for which respondents tapped retirement funds early.
Still, these findings make it clear that folks are twice as likely to prematurely tap retirement funds to pay off debt or bills as they are to use the money to survive a financial emergency such as a job loss.
The high cost of early retirement withdrawals
When you withdraw retirement funds early, it costs you more than the amount of money you withdraw. You also lose out on the earnings that money would have generated if it had remained in your account.
Further, if take an early withdrawal from a taxable account — such as a traditional 401(k) or traditional individual retirement account (IRA) — before the age of 59 1/2, you will generally incur a 10 percent penalty from the Internal Revenue Service.
There are exceptions to the penalty, but many types of debt and bills are not among them.
Let’s say you take $10,000 from your traditional IRA at age 45 to pay off debt or bills. Unless you qualify for an exception, it will cost you:
- The $10,000 by which you depleted your nest egg.
- The earnings that $10,000 would have generated by the time you would have withdrawn it in retirement. If the money otherwise would have sat in your account for another 20 years and earned a 7 percent rate of return during that time, it could have generated an extra $29,600 for you.
- The 10 percent IRS penalty — $1,000 in this case.
That amounts to a whopping $40,600 — not counting any earnings you could have generated by investing that $1,000 you used to pay the penalty. (For simplicity, we also did not include the taxes you would owe upon early withdrawal.)
So, if you are considering tapping retirement savings to pay off debt or bills, reconsider all your options — including the following — before proceeding:
- “8 Foolproof Steps to Get You Out of Debt Fast“
- “Quit Living Paycheck to Paycheck: This Tool Makes It Easy to Save“
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