Thinking of tapping into your retirement savings early?

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Depending on the options your plan offers, you will want to carefully consider the pros and cons before withdrawing money from your retirement savings.

When you need cash to pay bills or make a major purchase, it can be tempting to turn to your retirement account. But taking an early withdrawal or loan could hurt your financial outlook long-term, especially in retirement. If your plan offers early access to your retirement savings, and you’re eligible to take advantage of it, carefully consider it first. Weigh these reasons to avoid it vs. the potential benefits – and explore other options that could help.

Three reasons to avoid taking early withdrawals

Taxes and penalties can significantly reduce the amount you end up with.

Early withdrawals are subject to federal income taxes, and depending on where you live, state income taxes. Also, depending on the type of plan the funds are withdrawn from, you may have a 10% penalty tax as well (457 plans are not subject to the 10% early withdrawal penalty).

Consider this example:

A 45-year-old investor in the 22% federal income tax bracket who withdraws $25,000 from their 401k plan while still employed will owe a total of $8,000:

  • A $2,500 10% early withdrawal penalty
  • $5,500 in federal income taxes

In the end, they’ll only net $17,000 of the $25,000 they took out. Plus, they’ll pay more in taxes than they might have in retirement, when they may have been in a lower tax bracket.

You’ll miss out on compound growth, making it harder to reach your goals.

Money that doesn’t stay invested loses the chance to grow through compounding (when your earnings make more earnings of their own). Ultimately, that means you’ll need to save more money out of pocket to hit your savings target.

Consider this example:

A 35-year-old investor withdraws $10,000 from their account. If that money had been left in that account until age 65, and earned a 10% average annual return, it would’ve grown into almost $175,000. So, the true cost of the $10,000 withdrawal is much higher when you consider the growth they have now missed out on.

You may have less to live on in retirement.

Experts say you need to replace about 80% of your pre-retirement income to maintain your standard of living as a retiree. Social Security may replace less than 40%. If you withdraw money now and don’t have sufficient savings when you retire, you could face a shortfall between the amount you have and the amount you need. This could impact your quality of life throughout retirement.

The pros and cons of retirement account loans

Borrowing money from your retirement account can be a convenient way to meet a financial need — but the drawbacks can affect you in the long-run. Look into other borrowing options before you decide.

Pros Cons
There’s no loan application or credit report requirement. There’s a borrowing limit, which varies by plan. Loans also typically have to be paid back within five years unless it’s for the purchase of a primary residence. Check your plan for details.
You're borrowing your own money. Payments are made on an after-tax basis and may be taxed again upon withdrawal.
The loan can cover current debts at a potentially lower rate. Less money in your account means there is less opportunity for growth. You can miss out on compound earnings that could be higher than the interest that you are paying.
You don’t pay income taxes or receive a penalty on the amount borrowed. If you leave employment before repaying the balance, you may have to pay it off in full. If you don’t, any unpaid balances that remain may be subject to federal income taxes and a 10% early withdrawal penalty if you’re under 59 ½. It may also be subject to state tax, depending on where you live.
You are paying yourself interest. Your long-term investment strategy could be disrupted. Since the amount you borrow is no longer being invested, the way your assets are allocated could deviate from what you intended.

Other options to consider

There may be other ways to meet your short-term financial needs with less long-term impact. Here are several to consider:

  1. Reach out to creditors. If you're experiencing temporary challenges that are preventing you from paying your bills, contact creditors to ask about options. You may be able to work out a payment plan or pause payments.

  2. Reduce expenses. Look for line items in your budget to cut, even temporarily. Lowering your monthly costs can free up money to put toward debt or other goals.

  3. Check into other borrowing options that are available to you. Be sure to compare terms and interest rates to understand the details before you decide what’s best for you.

Carefully consider the long-term impact before taking money from your retirement savings. There may be other solutions to your current financial needs.

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To learn more about what options your plan offers and to decide what makes sense for you, contact us today.