A crash course in financial priorities
Two things are undeniably true when it comes to managing money.
- Being in debt is bad.
- Saving for retirement is good.
In an ideal world, you would have $0 in debt and tons of money saved for retirement. In the real world, most people have lots of debt and not nearly enough saved for retirement. This puts many people in a situation where they are asking themselves “Should I use my retirement savings to pay down debt?”
In this article, I’m going to explain why in most situations using retirement savings to pay down debt is a bad idea.
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.
Making early withdrawals from your 401(k) & traditional IRA before retirement age is a very bad idea.
For three reasons;
- Tax consequences and penalties
- Lost retirement income
- 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.
- 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.
- You’ll have a lot less money in retirement. This could jeopardize expensive retirement activities like travel.
- 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 lose that benefit 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.
The true cost of that early withdrawal is $350,000 in compounded returns. If you want to find out the potential compound returns you could earn in your retirement accounts you can use this free compound interest calculator.
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 remains why are people withdrawing funds from their retirement accounts?
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 mistake
I want to focus on the 44% of people who drained their retirement savings to pay off debt.
I’ll be as clear as possible; unless you have exhausted every other possibility, do not raid your retirement to pay off debt.
I have written extensively on 3 proven strategies to pay off debt. None of these strategies involve you draining your life savings.
These strategies include;
- Debt consolidation
- The snowball method
- The Avalanche method
The need for an emergency fund
Did you notice that 44% of respondents in that survey said they have made withdrawals from their retirement accounts to pay for financial emergencies? This makes me sad because that can easily be avoided with a bit of planning.
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 a 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.
If you don’t currently have a financial emergency fund set up, you need to change that as soon as possible. Here is a free tool that will help you determine how much you need in your emergency fund. It will take you less than 1 minute to find out what you need in an emergency fund. There. No more excuses as to why you don’t have cash set aside in case of an emergency.
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.