Why You Shouldn’t Touch Your Retirement Savings
You're considering tapping into your retirement fund before you officially retire. You've managed to set aside a significant pool of savings for yourself, and you still have time to contribute before you make your exit from work-life. What's the harm in making an early withdrawal?
Early Withdrawal Penalties
While people are free to make early withdrawals from their retirement funds, it's not a habit that's encouraged. Anyone who does make an early withdrawal before reaching 59.5 years of age will be subject to a 10% penalty from the IRS. If you have a SIMPLE IRA account, your penalty could be even higher than that - it could be as high as 25%.
In some cases, you can be exempt from these penalties. Take a look at the IRS's list of exceptions to tax on early distributions to see whether you can avoid it.
Additional Income Tax
In addition to the penalty, your early withdrawal will be subjected to ordinary federal and state income taxes. For 401(k)s, the IRS typically withholds 20% for these tax purposes.
So, if you took out $10,000 from your fund before you hit the age requirement, you could end up with $7,000 because of income taxes and the 10% penalty. That's $3000 out the window!
While you might be exempt from the 10% penalty, you will not be exempt from this part of the process.
Shrinking Your Safety Net
Another issue with early withdrawals is that you're taking funds away from your future self. You're shrinking your safety net!
Withdrawing retirement savings for non-retirement purposes is a bad habit to keep up with, and it could have consequences in the future. You could give yourself fewer funds to rely on when you don't have a full-time job. You're potentially compromising your retirement investment and your future financial independence.
The same financial rule applies to other savings funds. You shouldn't take funds out of your children's college funds for expenses outside of their education. You shouldn't take funds out of your emergency fund for expenses that aren't emergencies. Doing this undermines your savings goals and leaves you with smaller safety nets to fall back on when you need them.
What If It's an Emergency?
A retirement fund shouldn't be seen as a resource for emergency savings. This is why you should do your best to create an emergency fund in your financial portfolio. You can easily make withdrawals from your emergency fund to cover urgent, unplanned expenses.
How much should you save in an emergency fund? Ideally, you should aspire to have three to six months' worth of your income inside of a separate savings account. The amount should be enough to help you with small emergency expenses, like car repairs or home repairs. It can also help you pay for essentials in times when your income is disrupted (for example, job loss) and you need time to recover.
If you don't have an emergency fund and you need help paying for an unplanned, urgent expense, you still shouldn't look to your retirement fund as a solution. In this situation, you can turn to a credit tool for help.
Charge the urgent expense to your credit card and then steadily pay down the balance later. Or go to a website like CreditFresh and apply for a personal line of credit loan. If you're approved, you can use your line of credit loan to cover the emergency expense quickly. Then, you can follow a repayment plan and replenish your line of credit's balance.
Wait for the right time to touch your retirement savings. If it's too early, leave them alone!