How Early Withdrawals From an IRA or 401K Can Kill Your Retirement

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What is attractive about a 401(k) plan is that employers can match an employee’s contributions, either dollar-for-dollar or with a portion of each dollar, up to a certain percentage of the employee’s income.

So if you are saving $5,000 to $10,000 per year and your employer is contributing an extra $5,000 to $10,000 per year into your 401(k), the money can add up and start compounding quickly if you start early enough in life. And as your income increases, hopefully so too would your contributions.

Those who begin saving properly in their 20s should be able to retire comfortably, but what happens when savers start pulling that money in their 30s, 40s, or 50s? Life happens, and setbacks such as losing your job or needing the money for some urgent house repairs may tempt you to use the funds in your 401(k). Those early withdrawals can easily destroy your retirement goals of retiring to that ideal destination.

Contributions to a 401(k) are tax deferred, as is any growth, and owners do not pay taxes until they withdraw that money in retirement. In retirement, when owners are no longer in the workforce and have lower taxable income, hopefully they get to withdraw the money at a lower tax bracket.

Taking out a big sum at once or over a short period of time before retirement will have other long-term effect other than stealing from your future. And after an early withdrawal, you cannot make up that same tax-deferred money back.

The problems with early withdrawals are multi-faceted. First, you have to pay tax on the withdrawal at your current income tax bracket. And because the money was growing tax deferred, any withdrawals carry a 10% penalty. Further, and perhaps the most devastating, is the loss of compound interest — that is when withdrawing $25,000 from a 401(k) plan, say in your 20s or 30s, may destroy $100,000 or much more in future funds. Plus, accessing $25,000 even in just the 22% tax bracket and with the 10% penalty means that you would really only be getting to access about $17,000 in real funds.

It is good that the IRS has catch-up rules to allow older savers a better chance to have a good retirement, so the year you turn 50 and thereafter you can contribute an extra $6,000 per year on top of your $19,000 maximum annual contribution. But let us say you catch up with a combined $18,000 over a three-year period and the money only has 16 years on average versus the 35 year timeframe mentioned above. That $18,000 compounding at 5% over 15 years only grows to $37,420.

Robbing your 401(k) or IRA today comes with a big disadvantage your future retirement. If you are smart enough to invest into a 401(k) or IRA, also be smart enough not to rob it ahead of your time.