We’ve all thought about it. When a big expense comes up, it can be tempting to turn to your retirement account for extra cash. If you have the money in your workplace 401(k) to cover a home remodel or a child’s wedding expenses, you may ask yourself, Why not? After all, the average 401(k) balance right now is $103,700.1 So, when you need cash (or you think you need cash), the temptation to call your retirement plan representative and make a withdrawal can seem overwhelming.
Freeze! We want you to put down the phone and step away from the 401(k)! Any financial advisor will tell you it pays to keep your hands off your 401(k) until you retire. Don’t believe us? Take a look at the stories below and the consequences of covering big life events with your retirement funds!
The Most Common Reasons for Cashing Out a 401(k)
First, if you’re tempted to make an early withdrawal, you’re not alone. A recent study found that more than half of Americans with retirement accounts (51%) have taken an early withdrawal before reaching retirement.2 And the picture is even worse for younger workers. Almost half of investors younger than 34 years old (49%) have already taken out money from their 401(k).3 Half!
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The truth is that dipping into your 401(k) early—or cashing it out altogether—is going to cost you more than you might imagine. Not only are you going to get hit with taxes and withdrawal penalties, but you’ll also miss out on the long-term benefit of compound growth. It’s no wonder so many millennials later regret raiding their retirement accounts early. Don’t do it!
Why are so many folks dipping into their retirement nest eggs so early on? Here are some of the top reasons we hear about for cashing out a 401(k)—and why it’s almost always a bad idea.
1. Losing Your Job or Changing Jobs
Picture this: Your boss calls you into his office. You close the door behind you. Then you hear those words no one wants to hear: “I’m sorry, but we have to let you go.”
Just like that, you pack your desk and you’re out of a job—and, if you don’t have a ton of cash saved up in your 401(k) when you leave, you might just want to take that money and run. But the truth is that even a small cash-out can have a huge impact on your retirement savings.
Let’s take a look at Joe. At 25, he’s been working for a couple of years and just landed a new job. He decides to cash out the $4,500 in his 401(k) to pay for his move and furnish his new place. After all, it’s only $4,500, right?
Turns out that it’s even less. First of all, Uncle Sam keeps about 25% for income taxes. Then Joe also gets penalized with a 10% early withdrawal fee, reducing his $4,500 to a mere $2,925.
Worse, Joe will miss out on the long-term benefits of compound growth. What if he had rolled his 401(k) into an IRA when he left his job like he should have? Joe’s account could have grown to over $200,000 during the next 40 years, and that’s without adding another penny. Talk about a pricey mistake!
2. Education Expenses
So, maybe you’re not thinking about cashing out your whole 401(k), but you want to use a part of your nest egg to help you go back to school for a master’s degree. Or maybe you have a teenager about to graduate high school, and you’re behind on setting up a college fund for them. It’s for a good cause, right?
Most 401(k) plans allow you to borrow up to 50% of your account’s value up to $50,000, so it’s common for parents and young workers to turn to their retirement accounts when they don’t have the money to pay for college expenses. But, just because it’s common, it doesn’t mean it’s smart!
There are some nasty strings attached when you borrow from your 401(k). Here are a few of the consequences:
To start with, you have to pay back the amount you take out in a loan plus interest.
While investments in your workplace 401(k) are pre-tax, you pay back a loan with after-tax dollars—so it takes longer to build up the same amount of money.
You must pay back your loan within a certain time frame to avoid taxes and penalties.
If you leave your job for any reason, you’ll need to pay back the full loan balance by the due date of your federal income tax return.4
Those are a lot of negatives to consider. Here’s the bottom line: Your retirement savings come first, even before funding college for yourself or your kids.
Now, don’t hear me wrong: I think higher education is very important. But the fact is that you or your child can go to college debt-free by choosing an affordable school, working part-time, and applying for scholarships. I talk to people who do it all the time. Bottom line: When it comes to school, you have options!
Retirement is a whole different ball game. You’re going to heavily depend on what you have saved in your retirement accounts for basic life necessities—and you put yourself at risk when you borrow from your 401(k).
Prioritizing your retirement is not selfish—it’s a smart financial decision for your future.
3. Making a Large Purchase
Now, this one really gets me riled up. I’ve talked to way too many folks who drained their 401(k) or IRA just so they could renovate a kitchen or pay for a wedding—only to regret it later.
In fact, a recent survey found that two out of ten Millennials planning to buy a home expect to dip into their retirement accounts to fund their purchase. Even worse, almost a third of Millennials who are currently homeowners borrowed money from their nest egg to buy their house.5 That is a bad idea, people!
For example: Paula who, at 35, already has $100,000 in her 401(k) account. She comes down with a severe case of house fever and borrows $50,000 from her 401(k) for a down payment on a new home that’s way out of her price range.
It’ll take Paula eight years to pay back the loan with interest, and she’ll have to stop her contributions during that time. How much does it cost her?
Paula could lose more than a million dollars. Let that sink in. Do you really want your house to be the thing that keeps you from becoming an everyday millionaire?
Not only did she forfeit the compound growth that $50,000 would’ve earned her, but she also missed out on eight years of contributing to her 401(k) while she was paying back the loan. Ouch!
4. Paying Off Debt
Okay, when it feels like you’re being crushed by the weight of all your student loans, car loans and credit card payments, you might look at the money sitting in your 401(k) and think it would be so easy to just knock out your debt in one fell swoop.
We get it. Look, we want you to get out of debt as fast as possible, too. But your 401(k) is not the answer. We’ve already shown you how penalties and taxes will make a good chunk of your hard-earned savings go up in smoke. Plus, you’d only be digging yourself into a bigger hole when it comes to saving for retirement.
Trust me: It’s just not worth it. Instead, we want you to stick to your plan and stay focused. Keep working your debt snowball and knock out your debts one by one. Before you know it, you’ll be debt-free and ready to press on toward your retirement dream!
How to Avoid Cashing Out Your 401(k)
Your 401(k) isn’t there for emergencies or vacations or paying down debt—it’s there for retirement. When you borrow money from your 401(k) even just one time, you might turn your future retirement into one big emergency. And that’s not okay!
That’s why we want you to have a fully funded emergency fund in place before you start investing in a 401(k) or other retirement accounts. When you have a big pile of cash available at a moment’s notice, it can turn a major emergency into a minor inconvenience—and it’ll keep you from even thinking about touching your 401(k).
If you haven’t saved an emergency fund with 3–6 months of expenses, stop saving for retirement until you do!
And, by the way: Going on a family vacation or renovating your kitchen is not an emergency! If you know you have some major purchases or a vacation on the horizon, open up a “sinking fund” and set aside some money each month until you can pay for them with cash.
The only reason you should even think about taking money out of your 401(k) is to avoid bankruptcy or foreclosure. Otherwise, your 401(k) is off-limits until retirement. Period!
Stick With Your Retirement Plan
Life has a way of throwing the unexpected at you. That’s why it’s always a good idea to have a financial advisor you trust in your corner. With our SmartVestor program, you can connect with an investing pro who will help you make smart decisions about your future, and stick with your investments for the long term.
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.