Why People Are Draining Their Retirement Funds Early

And How To Avoid This Costly Mistake

Photo by kschneider2991 on PixBay
Some basic financial planning today, when you are young and healthy, will save you a world of financial hurt when you are old and grey.

Why You Should Not Make Early Withdrawals from Your Retirement Account

Making contributions into your 401(k) and traditional IRA is a very smart thing to do. Anything you can contribute could be eligible for a tax deduction.

The investments held inside those retirement accounts then grows on a tax-deferred basis. Those dividends and capital gains you earn inside your retirement account are not taxed until you withdraw the funds.

This allows you to benefit from supercharging your savings through decades of compound interest. It is the simplest way to grow your wealth.

Making early withdrawals from your 401(k) & traditional IRA before retirement age is a very bad idea.

For three reasons;

  1. Tax consequences and penalties
  2. Lost retirement income
  3. The opportunity cost of lost compound interest

Tax Consequences and Penalties

The immediate and obvious pain from making early withdrawals from your 401(k) and traditional IRA before the age of 59 1/2 are the taxes and penalties.

  • Right off the bat, you could be hit with a 10% withholding tax for any funds you withdraw.
  • Additionally, your withdrawal will be added to your taxable income and taxed at your marginal tax rate.

While it is true that you need withdrawals are taxable during retirement as well if you are working full time and make a significant withdrawal from your retirement accounts that could potentially push you up into a higher tax bracket.

A large portion of your withdrawal could be eaten up by penalties and taxes.

Lost Retirement Income

Let’s not forget why retirement accounts are called retirement accounts; Their intended purpose is to fund your retirement!

If you withdraw from your retirement accounts today, there are three possible outcomes.

  1. You need to significantly increase future contributions and savings to make up for the withdrawal. This will limit your future consumption as more money needs to be saved.
  2. You’ll have a lot less money in retirement. This could jeopardize expensive retirement activities like travel.
  3. You will need to work longer than you originally planned.

Personally, none of those options sound appealing to me.

The Opportunity Cost of Lost Compound Interest

Remember that all the funds inside your retirement accounts can grow a tax-deferred basis until retirement. That provides an incredible opportunity to let compound interest do most of the heavy lifting to fund your retirement. You lost that benefits if you make an early withdrawal.

Let’s say you make a $50,000 early withdrawal from your 401(k) at the age of 30. That will set your retirement funds back a lot more than $50,000. Assuming a 7% rate of return on investment, that $50,000 would be worth over $380,000 by age 60.

That true cost of that early withdrawal is $350,000 in compounded returns.

Hopefully, by now you agree that making early withdrawals from your retirement account is a very bad idea. Yet Millions of people raid their retirement accounts every year.

Why People are Making Early Withdrawals from Their Retirement Accounts

The big question then is why do people do it?

A survey from Go BankingRates provides answers. They asked people who made early withdrawals from their retirement accounts why hey did it. Here were their responses;

  • 44% to pay off debt or bills
  • 22% to cover a financial emergency
  • 22% to cover medical expenses
  • 9% to purchase a home
  • 3% to pay for higher education

How to Avoid This Costly Financial Mistake

I’ll leave the 12% alone who withdrew to pay for a home or higher education and focus on the other 88%.

44% Raided Their Retirement to pay off debt or bills

Let’s start here because this is the easiest one to address. Unless you have exhausted every other possibility, do not raid your retirement to pay your debts or bills.

I have written extensively on strategies to pay off debt that do not involve draining your retirement accounts.

these strategies include;

  1. Debt consolidation
  2. The snowball method
  3. The Avalanche method

If you have not already, go read this story.

44% Raided Their Retirement to cover Financial Emergency or Medical Bills

I am lumping the people who responded to cover a financial emergency and medical bills into one category which I’ll simply refer to as emergency expenses.

This is where a properly funded emergency fund comes into play. The conventional wisdom is that you should have 3 to 6 months of living expenses kept in a savings account in case of financial emergency.

I know it might seem boring and could take a long time to save that much cash, but you will thank yourself one day for doing it. Most people tend to think that a job loss or a significant medical expense will never happen to them.

These are the same people who are sacrificing their retirement to cover for these expenses they never thought they would have to deal with.

Bottom Line

Early withdrawals from your retirement accounts are extremely costly and, in most cases, completely avoidable if you are willing to address your debt situation head-on and create a financial emergency fund.

Put simply, some basic financial planning today when you are young and healthy will save you a world of financial hurt when you are old and grey.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions