If you've hit hard times and need some money, you may be thinking about making an early withdrawal from your 401(k) plan.
You shouldn't make this decision lightly and I'm happy to have DJ from My Money Design on the blog today to go over this subject.
Here's what DJ has to say and I second his thoughts:
In an effort to help millions of financially struggling Americans, one of the benefits of the new Coronavirus Relief Bill (or CARES Act) is that it will let you dip into your IRA or make a 401(k) early withdrawal penalty-free.
For many people, this seems like a huge opportunity to get some much-needed money to cover your expenses. Not only does it remove the hefty 10% penalty that you’d normally have to pay if you’re under the age of 59-1/2, but it also opens the door to money that was previously not accessible.
However, just because the restrictions have been relaxed, does that necessarily mean it’s a good idea to go this route? Though the prospect of using money that many people think is just “sitting there and doing nothing” can be tempting during hard times, the truth is that this money is in fact doing something very important.
Most financial experts agree: Raiding your retirement plans should always be considered as a last resort option. And if you dip into too early, there will be some long-term consequences that will need to be considered.
Here’s what you need to know about making IRA or 401(k) early withdrawals.
Reducing the Power of Compounding Returns
What makes our retirement funds so special in the first place is that they are designed to grow at a rate beyond anything we could ever save under our mattress. This is mostly thanks to the power of compounding returns and tax deferment.
Compounding returns are the earnings we make off both the money we invested and any previous earnings that we’ve already accumulated. The more money we have, the more potential there is for growth, and on average this cycle is what grows our nest egg year after year.
This is why we have to be very careful when considering a withdrawal or even a loan from our 401(k) plan. Even a small amount can have huge financial implications and sabotage your earning potential for years to come.
For example, if you’ve currently got a nest egg of $100,000, in 20 years it might be worth $672,750 if we assume an average annualized growth rate of 10%. But if you were to take out $50,000, then as you might expect, your nest egg would only have the potential to grow to half of that value $336,375.
In addition to this, the nature of our retirement plans is that they are tax-deferred. This means that unlike a traditional investment account, our investments grow and multiply for years (or even decades) without us having to pay taxes on the gains. To illustrate this using a scenario from an article by the Motley Fool, a person investing $5,000 per year for 30 years and making an average 8 percent return could expect a difference of $612,000 using a tax-deferred plan versus $419,000 using a taxable one. That’s no small difference!
The smartest thing you can do to maximize the power of compounding returns and tax deferment is simple: Leave your money right where it is.
Never Sell Low
One of the oldest and most well-known investing staples is the mantra to “buy low and sell high”. Ideally, investors hope to swoop in when market values are low, buy up assets at a discount, and then sell them later on when the markets have improved.
However, by making any sort of withdrawals from your retirement plans right now, you’d most likely be doing the exact opposite of this. Unfortunately, at the moment, the markets are approximately 25% off from their all-time highs. That means any withdrawals at this point would effectively be locking into these reduced values as well as resulting in the need to sell more shares to achieve the value you’re looking to take out.
Consider 1,000 shares at $100 each for a total of $100,000. If you need $20,000, but those shares have now depressed to being worth only $75 each, this means you’d have to sell 267 shares instead of the normal 200 shares. Even if those remaining 733 shares got back up to $100 each, your portfolio would still only be worth $73,300.
Don’t Forget the Taxes
Though the CARES Act does allow for penalty-free withdrawals from your retirement plans, this does not make them tax-free. Any withdrawals that are taken out under the terms of hardship and not paid back will be subject to Federal Income taxes that must be paid within three years. And that could end up working out to quite a substantial tax bill to pay!
For example, if you were to withdraw the maximum amount allowed of $100,000 and your effective tax rate is approximately 20%, this means you’d end up owing $20,000 in taxes. Even if you split that up over the three-year allowed period, it still works out to an extra $6,667 in taxes each year.
On top of that, since this withdrawal would be counted on top of your regular earned income, there is the potential that it could knock you into a higher marginal tax bracket, meaning you’d potentially owe even more money.
On this point alone, before making any withdrawals at all, you’d definitely need to consult a tax professional and make sure you understand the implications of what you’re signing up to.
What You Should Do Instead
Though its never the answer anyone wants to hear, the first thing you should do in times of financial distress is to tighten your belt and curb your expenses. Take a long, hard look at your spending habits and start making cuts where you can immediately. Everything should be on the table for consideration, even if it’s only just a temporary move such as freezing your streaming services or gym membership.
Instead of taking money out of your retirement plans, another strategy could be to reduce the amount of money going into them. You could lower your contributions or even turn them off altogether temporarily. However, if your employer matches your 401(k) contributions, be careful not to go too low and sacrifice receiving free money.
As the old saying goes, don’t be “penny wise and pound foolish”. Though dipping into your retirement funds may seem like an easy solution, think about the consequences. Take every other action you can before making an IRA or 401(k) early withdrawal.