Feel Compelled to Tap Your Retirement Savings? Do These Things First
KEY POINTS
- Raiding your retirement savings could result in penalties and a financial shortfall later in life.
- Before you tap your savings to cover a near-term bill, see if there's an affordable way to borrow.
- It may also be possible to take on a side job to drum up the cash.
The purpose of having retirement savings is to have money for -- wait for it -- retirement. But there may come a point when you're tempted to tap your individual retirement account (IRA) or 401(k) ahead of retirement. That scenario might arise when you have a home repair to cover. Or maybe your car gives out on you and you unexpectedly need to replace it.
A December 2023 survey by Betterment at Work found that 30% of workers tapped their retirement accounts over the previous 12 months to pay for short-term expenses. But going that route could have serious consequences.
The problem with tapping your retirement savings when you're not retired
The IRS offers some pretty sweet tax breaks for funding a traditional IRA or 401(k) plan. Not only does your money get to go in on a pre-tax basis, but you're not taxed on investment gains year after year. Rather, those gains are tax-deferred until you take withdrawals.
But in exchange, the IRS wants the money in your IRA or 401(k) reserved for retirement. And if you take a withdrawal prior to age 59 1/2, you'll usually be hit with a 10% penalty on the sum you remove. This means that a $5,000 withdrawal for a home repair will cause you to lose $500 right off the bat.
But that's not the only issue. An even bigger problem is that tapping your retirement account early will leave you with less money once your retirement actually kicks off.
Let's say your retirement account is invested heavily in stocks so you're getting a 10% average annual return, which is in line with the stock market's long-term average. If you take a $5,000 withdrawal at age 35, you might end up with $87,000 less by age 65 when you account for the fact that you didn't enjoy that growth on your $5,000 for 30 years. That's an even bigger problem than your $500 early withdrawal penalty.
Alternatives to consider
Clearly, raiding a retirement plan ahead of retirement could put you in a bad spot down the line. So before you do that, think about ways you might be able to borrow affordably for a sudden expense. If you have great credit, you may find that a personal loan or home equity loan gives you access to the money you need without an exorbitant interest rate.
Also, if you have a near-term need for money but don't necessarily need the cash right away, it may be possible to hustle at a side gig to come up with the funds you require. For example, if you discover that your air conditioner needs a $700 repair but it's April and you're not really planning to start using it until June, you could try to earn an extra $100 a week to cover the cost.
All told, it's not a great thing to tap your retirement savings. In addition to coming up with alternative ways to get your hands on money in a pinch, pledge to start building an emergency fund. That way, you'll have cash reserves in the bank you can access when surprise expenses arise, and you won't have to worry about early withdrawal penalties or lost investment gains.
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