Should You Break the Piggybank?
When you lose your job or have unexpected bills, your finances are negatively impacted. Looking at the funds you saved in a retirement account may seem like an attractive and simple way to help. But if it looks too good to be true, maybe it is.
If you have a pre-tax retirement account, like a Traditional IRA, you can take distributions whenever you want. However, if you are under 59 ½, there is a 10% penalty for early withdrawal. You will also have to pay taxes on the amount you take out. This withdrawal could be the most expensive money you ever have.
Now it is true that there are some exceptions for taking distributions without a penalty, such as being a first-time home buyer. With the advent of Covid-19, there is a new waiver of the penalty for those affected.
Before you take money out of your retirement account, understand the reason you are saving for retirement. It is so funds will be there when you need them when you are retired or are unable to earn active income from a job. If you withdraw retirement funds now, what will be left for your future financial security?
Say you need $20,000 and decide to take an early Traditional IRA withdrawal. If your personal income tax rate is 24%, you will lose $4,800 to tax. (If your withdrawal does not qualify for an exemption will you lose $2,000 of it off the top in the form of penalty).
You withdraw $20,000 but end up with only $13,200 in your pocket, which is a little more than half the amount you were seeking to get in the first place. That is just one reason why an early IRA withdrawal rarely makes sense — because you do not end up getting anywhere close to the full amount you needed.
Losing the Benefits of Compound Profits
The tax hit is painful enough, but there are other issues to consider. If you take funds from your retirement account now, you lose the potential amount of profit those funds could have generated when making investments. If you had left that $20,000 alone for 25 years and it averaged a 10% annual growth rate that $20,000 would eventually turn into more than $240,000.
Your retirement account is designed to help you when you retire, it is not for present benefit. As personal finance expert Chris Hogan states, you should only take early retirement funds to prevent a foreclosure or a bankruptcy.
So again, you can take personal possession of the funds in your IRA account (or 401(k)) but before you do, consider the consequences of breaking the piggy bank.