Figuring out how to allocate your money toward different goals is something a lot of people struggle with, and if you’re fortunate enough to have been able to save and invest money for retirement, you might assume it’s okay to use it for other purposes if you need to.
Clever Real Estate amassed personal finance data for 2023, and found that 26% of Americans surveyed admitted to dipping into their retirement savings last year. It’s their money, and using it for purposes other than retirement may have saved them from taking on costly debt, so what’s the harm? The impact could be huge, actually.
Tax penalties and lost potential
If you have a 401(k) plan through your employer or a retirement account you opened on your own (like a traditional IRA), the money in the account belongs to you, and it might be tempting to withdraw money if you run into a financial snag. Unfortunately, if you do, you’ll face some unpleasant consequences.
First, your early withdrawals from a tax-advantaged account (meaning, you fund it with pre-tax dollars) are subject to taxes and penalties. The IRS notes that unless you qualify for an exception (such as by being totally and permanently disabled), you’ll have to pay income tax on the money you withdraw — and there’s likely to be a 10% penalty on top of that.
But the biggest impact of an early retirement plan withdrawal is the loss of compound interest growth (when your invested money earns more money). The money you save and invest for retirement could possibly earn a 10% average annual return over time (this is in line with the stock market’s performance over the last 50 years), and by pulling out some of that money early, you’re stunting its growth potential. Of course, past performance does not guarantee future returns.
Consider this: A $10,000 withdrawal from your IRA in 2024 might just equal $10,000 now. But if you left that money invested in the account and earned even just an 8% return over the next 30 years, it could grow to be worth more than $100,000. Clearly, it’s best to leave your invested cash alone. But how can you deal with expenses that your normal budget won’t cover if you don’t want to withdraw from a retirement account?
Increasing your income will give you more breathing room
If you’re struggling to cover surprise expenses beyond your everyday bills, you’re in good company — according to SecureSave, 63% of workers couldn’t handle a $500 emergency expense out of their savings. For many people who have retirement savings, dipping into that money is a way to avoid taking on debt for an unplanned bill. The best way forward is to work on saving an emergency fund, but your current salary may not support this endeavor.
Ultimately, the most effective way to improve your financial circumstances and give yourself more wiggle room to cover life’s little (and big) emergencies is to increase your income. I spent years in a career with low earning potential, and it wasn’t until I changed careers and then became a full-time freelancer that I managed to break out of the paycheck-to-paycheck cycle (and I have never had retirement savings of any kind to tap).
This move is likely a bit drastic for most people (what can I say, I have a long history of jumping into things with both feet), but it’s not your only option to increase your income. Maybe you can talk your way into a raise at your current job, or add a casual side hustle (such as driving for a ride-hailing service a few nights a week). Any extra money you can bring in won’t already be earmarked for bills, and you can stick it into a high-yield savings account for a rainy day.
Cutting your spending can help
Consider reducing your regular expenses, too — and not necessarily by giving up all your fun spending. You’re likely overpaying for some aspect of your regular life. You could shop around for a new internet service provider, cellphone plan, or insurance coverage. It takes a little time to do the legwork, but you really could shave significant money off your bills — my colleague Dana George saved $1,646 in 2023 by switching insurers.
Your retirement savings are for your retirement — and it’s a lot harder to cope with a lack of money at a stage of life where it’s apt to be a lot more difficult to increase your income by working. Do your future self a favor and try to leave your 401(k) or IRA balance alone to grow for your golden years.
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