Sometimes in life, you have two choices: “bad” and “worse.”
That’s probably the case for many residents of the Southern U.S. who just lived through hurricanes Harvey and Irma, the worst storms to strike the country in more than a decade.
Millions of people now face unexpected expenses as they repair their homes and try to stitch together other threads in the torn fabric of their lives. And given that more than two-thirds of Americans have virtually no savings, it’s a safe bet that few of these folks have any money squirreled away for what has proven to be the ultimate “rainy day.”
Clearly moved by their plight, U.S. Rep. Kevin Brady, R-Texas, has come up with what seems like a compassionate gesture. Brady is thinking about introducing legislation that would temporarily remove the 10 percent penalty that most people incur when they withdraw funds from their 401(k) plans before age 59 ½. The exception would apply only to people impacted by Harvey and Irma.
Undoubtedly, this would provide financial help to hurricane victims when they need it most. But just for the short run. And taking advantage of Brady’s idea could prove disastrous in the long run.
Cracking your retirement nest egg
To explain how Brady’s seemingly good idea could turn so bad, a little simple math is in order.
Let’s say you live in Houston, and you got off relatively easy during Hurricane Harvey. Flooding caused $5,000 in damage to your house, a significant — but not financially disastrous — sum. You need to make minor repairs and replace some waterlogged furniture, but it’s nothing that can’t wait a little while.
Unfortunately, you are among the many millions of Americans who do not carry flood insurance. To fix your damages, you use Brady’s proposed loophole and withdraw the necessary money.
In itself, that might not be a bad idea. But only if the Brady proposal allows you to you pay the money back into your 401(k) account at some point. And only if you do so quickly.
But let’s say you don’t. And given Americans’ chronic inability to save, there’s a good chance you won’t.
In that case, the $5,000 missing from your 401(k) account can quickly become a giant black hole that sucks up many of your retirement hopes and dreams.
If the S&P 500 grows at 10 percent annually — roughly its historical average — investing that $5,000 in an index fund inside your 401(k) would leave you with about $87,000 after 30 years. Exercise a little more patience, and the money would grow to more than $226,000 after 40 years.
Or, you could end up with zero dollars — if you withdraw the money from your 401(k) plan and never replace it.
And it could get even worse. Brady has not yet revealed many details about the proposal he’s considering. However, some reports have indicated that withdrawing money early will still require you to pay taxes on the amount.
And it’s possible that even if penalties are temporarily lifted, the Brady proposal will include a provision that re-imposes penalties on people who never pay back the money.
Look at alternatives to pay for repairs
To be fair, organizations such as the American Retirement Association have voiced support for allowing Americans to tap their 401(k) accounts in the wake of a disaster. And certainly, there might be circumstances where prematurely withdrawing 401(k) money to pay for hurricane costs is the best of a bad array of choices.
Still, the potentially life-altering consequences of prematurely withdrawing money from a 401(k) account is a chief reason why many experts say you should exhaust all other alternatives before cracking open your nest egg prior to retirement.
It’s also why economist Douglas Holtz-Eakin, former director of the Congressional Budget Office, thinks Brady’s proposal is a bad idea.
Holtz-Eakin told the Washington Post that there is a “long list” of programs that can help hurricane victims, including community development block grants and small business loans.
He believes lifting the 10 percent penalty will tempt too many hurricane victims to make bad choices. Holtz-Eakin told the Post:
In the best case, a smart person will understand the trade-off and make the right decision. In the worst case, they will just follow the government incentives rather than do what’s best for them in the long run.
Brady has yet to formally introduce any legislation. But even if he does — and it becomes law — consider all your other alternatives. It’s almost certainly better to get a part-time job, postpone your spring trip to Europe, or simply tighten your belt several notches for a year or two instead of prematurely tapping your 401(k).
Your future self is likely to thank you while sipping colorful drinks on a quiet beach somewhere.
For more ideas on generating cash quickly, check out:
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