Your retirement fund is a place that you can invest money you earn today so you’ll have a nest egg to support yourself when you finally stop working for good. Retirement may be decades away for you and in the meantime, you may be tempted to pull money from your retirement fund for some of your other financial goals. People commonly dip into their retirement to cover a down payment on a first home, for home improvement or repairs, to cover medical bills, or to pay for a child’s college education. While you may be able to make penalty-free withdrawals for these reasons, the consequences of early retirement withdrawals may be far-reaching.
Three Reasons You Shouldn't Withdraw From Your Retirement Too Early
You may not get a chance to pay it back. While your intentions might be to put the money back as soon as you can, the truth is, your finances may not line up to let you do that. That means you’ll end up with less money in retirement than if you’d never taken out the money at all.
You’ll miss the compound interest. Compound interest is how your retirement savings is able to grow over time, even beyond your contributions and employer match. As your retirement account earns interest, it’s added to your balances and your new, higher balance earns more interest. Compound interest works best over a long period of time. However, if you take money from your retirement account, you’re missing the opportunity for that money to grow with interest payments. Even if you replace the funds later, you’ll still miss the interest earnings you would’ve had if you hadn’t touched your retirement savings.
There may be tax consequences, depending on the type of retirement account you withdraw from. If you withdraw from a pretax 401(k), the withdrawal amount is subject to taxation at your current tax rate. You might also have to pay an early withdrawal penalty with with a few exceptions, like a hardship withdrawal or to cover medical expenses that exceed 7.5% of your adjusted gross income. Between taxes and penalties, you could lose up to 50% of your withdrawal.
Could You Take Out a Retirement Loan Instead?
You might consider taking out a 401(k) loan rather than a withdrawal. You won’t pay any taxes on the loan and your retirement savings won’t suffer much as long as you repay the loan. However, you have to repay the loan within a certain amount of time before it’s considered a withdrawal. And if you leave your job before the loan is fully repaid, the remaining balance may be due all at once or else it will be treated as a withdrawal. Finally, if you have to stop contributions to repay your loan, you’re missing out on those contributions plus any amount that your employer matches.
Save Your Retirement Money for Retirement
While the money in your retirement account is yours, it’s important to avoid treating it like a savings account. Outside of the financial penalties you pay for an early retirement withdrawal, it can also affect your final retirement savings. Not having enough money in retirement can mean you have to work longer than you anticipated or you have to downsize your life more than you expected.
Early retirement withrawals should only be done as a last resort, after all other options have been exhausted. Avoid it if you can. Your future retired self will appreciate you for it.