I’ve seen so many instances where people think of their retirement savings as their emergency fund or as savings for their short-term goals which they then leverage for minor emergencies, non-emergencies and for other financial obligations or goals they have through loans or withdrawals....but is this ok? My thoughts? It really isn't a good idea unless it's a dire dire emergency. Let me explain.
Here's what happens when you take money out of your retirement savings
Withdrawing or loaning money from your retirement savings can have adverse effects on your wealth building efforts over the long term for a number of reasons.
- For one thing, you stand to lose the potential long-term gains/earnings you would get if your money remained invested and was working for you.
- In addition, you will lose out on the effects of compounding interest when you take money out of your retirement savings accounts.
- If you contribute to a tax-deferred retirement account, for instance. a traditional IRA, 401k, 403b etc and you withdraw your money before your eligible retirement age (e.g. when you leave a company or from an IRA), you will be liable to pay income taxes as well as an additional penalty (10%) on the total amount withdrawn.
- If you are making a withdrawal from a non-taxable retirement account e.g. a ROTH IRA, while your contribution balance is non-taxable, you will still be liable for income tax on your earnings as well as the 10% penalty based on the total amount withdrawn.
Considering all the reasons mentioned below, you stand to lose a lot of money due to missed opportunity and associated penalties by taking early withdrawals from your retirement savings. But what does this look like in actual numbers?
Here's an example of what happens when you take money out of your retirement savings
Let's say that right now you are considering taking out $1,000 of your retirement accounts as a withdrawal or a loan.
Let's also assume that the average return on your investment for the next year is ~8% - at the end of that year, you'd have $1,080 in your account.
Let's them look another year into the future - based on annual compounding and if the return on your investment the following year after is also 8%, you'd have $1,160 in 2 years from an original investment of $1,000.
Impact of an early withdrawal: If you decide to take out this $1,000 right as an early withdrawal, you'd have to pay the following (Let's make another assumption that you are at a 30% tax rate):
- Early withdrawal penalty - 10% = $100
- Federal & state tax withholding = $300
The balance you would then receive would only be $600.00
Impact of taking a loan from your retirement savings
If you decide to take out a loan, depending on the timeframe of your loans, your $1,000 would miss out on the potential earnings and compounding. And while you won't be subject to paying a penalty or taxes since it's a loan, you will be paying interest, and like many people who borrow from their retirement accounts, you might have to reduce or stop your retirement contributions all together in order to be able to make the loan repayments so the lost opportunity is even greater.
"By taking money out of your retirement savings, you stand to lose a lot due to missed opportunity and associated penalties."
However, if you left that money alone for 10 years, the potential future value of your $1,000 retirement savings could be $2,159 - assuming an average return of 8% over that 10 years (based on the historic performance of the stock market long term) and since this is an average return it would be despite spikes and dips in the stock market.
$600 vs. $2159.
The difference is major.
And this is only based off $1,000.
If it was based on $10,000 then it would be a difference of $6,000 vs. $21,590.
Yup, let that sink in.
So how can you avoid taking money out of your retirement savings?
1. Build up your emergency savings
To start, it's important to focus on building a solid emergency fund (your goal should be 3 to 6 months - more is better) so that if you need some extra cash due to an unexpected occurrence, you can leverage your emergency savings as opposed to having to tap into your retirement savings.
Don't have an emergency fund in place yet? Set an initial goal to get to $1,000 asap then work on paying off any high-interest debt you have and then get your emergency savings to 3 to 6 months of your basic living expenses.
2. Start savings for your short to mid-term goals
Next, create savings accounts for your short to mid-term goals, which basically the money you need to have access to in less than 5 years e.g. buy a house, taking a trip buying a car etc and start saving towards those goals. Building these saving goals into your monthly budget will help ensure you are allocating funds towards then each paycheck and over time you'll be surprised at the progress you make.
Need help with creating a budget? Browse through my blog posts on budgeting.
3. Understand that your retirement savings is off limits
You do a disservice to your future self if you are not prioritizing your long-term financial well being. So unless it's a dire life-threatening emergency, you need to make your retirement savings off limits and instead plan out your finances accordingly to cover any upcoming expenses or goals you want to fund.