Why Do Some Americans Tap Their Retirement Savings Early?

By Eshani Haque (Zacks)

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Over the years, with timely and regular contributions, you’ll likely be able to carve out enough savings to secure a peaceful retirement life for yourself. But by dipping into it prematurely, you are certainly putting your retirement life at stake, unless you have an enormous amount (and enough to spare) stacked in your retirement accounts.

Before we get to the core of this topic, let’s discuss how early withdrawals (i.e., before the age of 59 ½) from retirement accounts can affect your nest egg.  

Early Withdrawal Penalties

When you withdraw a portion of retirement money from traditional 401(k) or IRA accounts prior to age 59 ½, you are charged a penalty of 10% on the amount withdrawn. This is in addition to the taxes that you have to pay in case of withdrawals from these accounts at any point of time.

There is a list of cases (like disability, first home purchase, rollovers to other retirement accounts etc.) where you are exempt from paying the 10% penalty. Unless you fall under this purview, you will end up paying the penalty fee.

Impact on the Value of Nest Egg

Let’s take an illustrative example to see the real effect on your nest egg when you make an early withdrawal.

Here we have restricted our understanding to a 401(k) plan early withdrawal. Assuming that you still have 20 years left until retirement, when you withdraw $20,000 from your account, you end up losing $93,219 of your total nest egg value given an average annual return of 8%.

So, how did $20,000 lead to a loss of $93,219 from your total retirement savings? That’s because of the compound interest that your money could have got you had it remained in your account those 20 years. Thus, by tapping your retirement account early, you are not just losing out on the amount itself (besides paying heavy taxes) from your retirement years, but also on the income growth that the money could have fetched you.

Debt Repayment at the Root of Early Withdrawals

Per a survey conducted by GOBankingRates, approximately 44% of Americans have withdrawn from their retirement savings early to pay off debt and bills. The second-most common reason cited for early withdrawals was medical expenses or healthcare and financial emergencies. 21.7% each of those surveyed chose the above two factors as their reason to withdraw money early. Meanwhile, 9.3% of the individuals surveyed said they needed the money to purchase a home and a mere 3.3% used it on higher education.

A high debt level, especially when you have multiple debts with high interest rates, can wreak havoc on your personal life, damaging your efforts to save for the long term. In such a situation, it is of little wonder that you would fall back on your retirement money, without any other source of funds to address the issue.

However, before laying your hands on your retirement money, you should first attempt at compromising your lifestyle when contemplating debt repayment. By assuming a modest life, you can free up some savings for reimbursement purpose. A few skipped outings, vacations and lavish meals can help immensely in getting you out of debt quickly. If need be, try cutting your daily and monthly expenses as well. Apart from lifestyle changes, you could take up a part time or freelance job to supplement your income. The extra dollars that you earn can be used for loan repayment.

Meanwhile, financial emergencies like a job loss can crop up at any point in life. Ideally, immediate financial needs should be addressed by using emergency funds. These funds should stock substantial liquid cash to cater to erratic financial needs.

Finally, although you will be allowed to withdraw your money penalty free in case of medical expenses, exceeding 10% of your adjusted gross income (both 401(k) and IRA), first time home purchase (only IRA) and higher education fees (only IRA), these expenses are best met using some other sources. For instance, you could take up a student loan to pay for education fees or borrow a mortgage loan to buy your first house. Also, in the absence of healthcare insurance, emergency funds can serve purposeful in paying large medical bills.

In other words, retirement vehicles should never be considered as a source of meeting expenditures in your working years. Although you will not be liable to pay the 10% penalty in the aforementioned situations, by tapping your retirement money early you will still hamper the tax-deferred growth.

Concluding Comments

Unless absolutely necessary, retirement instruments are best saved for your retirement years. Without a steady source of income, you could jeopardize your golden years if you tap your retirement money early. Moreover, retirees are becoming increasingly vulnerable to early depletion of their nest egg, thanks to rising life expectancy and healthcare costs. Given this stringent scenario, you may be doing a great deal of harm to your retirement life by resorting to an early withdrawal from your retirement account. So, your best bet is to compromise on lifestyle and rely on some other sources to meet finances.

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