You’re in a financial bind. Maybe you lost a job. Maybe your health went south. Maybe your car broke down. You need cash now, and you don’t know where you’re going to find it. Payday loan? The rates are ridiculous. Bad idea. Running up credit cards? It’s not a payday loan, but it’s still high interest. If you get behind on payments, your rate may soar to as high as 29.99%. Bad idea. Raiding your retirement savings? Not a great idea, but at least it doesn’t build debt, right? Is raiding your retirement savings the best of several bad options?
30M Americans Tapped Retirement Savings Early for an Emergency. So said the USA Today headline. That’s a lot of people, though it’s a lower percentage of Americans than reported raiding retirement funds in 2011 (19% vs 11%). The good news? It’s not the youngsters doing this. Only 8% of those reporting early withdrawals were Millennials. No, it was those between ages 50 and 64 who were the most likely to withdraw early. The ones who should be most concerned with retirement were the ones raiding their funds.
So why are Americans tapping retirement savings? Because they lack emergency funds. Or at least adequate emergency funds.
The Costs of Raiding Your Retirement Savings
When I worked doing admin for a used book company, I was always surprised by the high percentage of people who cashed out their 401Ks on leaving. Going back to step one in saving for retirement and paying the tax penalty seemed like a really bad idea. But in hindsight, maybe I shouldn’t have been surprised. Most of those cashing out their 401Ks were young, with 40 years until retirement. Most of them were living paycheck to paycheck, and needed some cash to help with the transition from one job to another. With plenty of time and no savings, taking money from retirement savings must have seemed like a reasonable option.
But was it? I’ve talked before about compound interest and how it can work for you. Taking $1 from retirement savings now costs way more than $1 later. Compounding works exponentially. Putting $10,000 away for 40 years adds up to a lot more money than the same amount of money for 30.The key to retirement savings is to let that money work for you in your investments, so that you accumulate more than you put away. Raiding your retirement funds kills your chance to grow your savings effectively.
Another problem is that once you take out your retirement savings, it’s taxed as income. If you have to cash out a 401K or an IRA, your withdrawal is taxable on your income taxes. In addition, if you are under age 59 ½, you have to pay a 10% penalty to the IRS. That penalty stands even if you are withdrawing from a Roth IRA. And if you are withdrawing from a Roth, you will also have to pay taxes on any gains you take out.
But what if you meet the criteria for a hardship withdrawal from your employee retirement account? There are limits to how much you can take. There are income taxes. Plus you can’t contribute money to your 401K for at least 6 months, losing valuable time to make up the losses.
A loan against your 401K has limits as well. Not all companies let you borrow against your 401K. You are generally limited to $50,000 or 50% of your vested balance. The repayment terms aren’t bad: one point above prime, and it goes back into your account. As long as you stay in your job, you have 5 years to pay it back. But if you leave your job, voluntarily or not, you have to pay back the loan immediately or pay tax and penalties on what remains outstanding.
In all, raiding your retirement savings has immediate costs, in the form of taxes and penalties; and it has long-term opportunity costs, in terms of denying the compounding effects of saving. It’s an expensive option for generating extra cash.
How Not to Raid Your Retirement Savings
If you don’t have an emergency, build up that emergency fund.
Most people who use their retirement savings for emergencies do so because they don’t have enough other savings. But life happens. Everyone has a crisis eventually, so start preparing. If you aren’t used to living below your means and saving some money outside of your retirement funds, you will need to make some changes. Better to start while they are relatively painless than during a true emergency. Start setting a certain amount each month to go into your savings, and don’t touch it until you’ve reached your goal. A solid emergency fund usually covers 3-6 months of expenses, but you may want to go higher.
Saving money can be a challenge at first. Start with one or two things you can do differently and put the savings from those changes in your emergency fund. Change your cell phone service. Cut the cable cord. Cut back one meal out a month. Or add some extra income through a second job or side hustle. Every dollar helps, and there’s lots of good blogs and other resources that can help you figure out ways of living below your means, like this list of 100 tips.
And if you are in an emergency, find another way.
Emergencies are stressful, financial stresses can be hard to talk about. But you need to talk about them, because my first piece of advice is to start talking. Ask for help. Maybe family members can help, or maybe not. If they help, make sure you are clear on whether they are giving you a loan or a gift. If family members are loaning you money, get your agreement down in writing to protect both sides by clarifying the terms of the loan. They’ll likely charge you less than the 10% penalty for early withdrawals.
Even if your family isn’t in a position to help, you may find that you can work out a payment plan to help spread out the cost of an emergency to something you can manage. Medical providers in particular are used to working out terms with struggling patients. But you won’t know about other options unless you ask. In an emergency, always ask for better terms.
Once you’ve asked for help, it may be time to sell what you have, whether it’s personal items, second vehicles or other investments. It may take a little time, but most of us have things that we can part with if we need to. Or sell a service to get extra money, like taking on a gig on Craigslist. Getting extra money together can take time, but so does getting money out of a retirement account.
And If You Have To…
In a true financial emergency, raiding your retirement savings may be the best of bad options. Just make sure it’s an actual emergency and not an inconvenience, and that you’ve exhausted other alternatives. The costs are high, but not as high as going to a payday lender or racking up credit card debt.
Have you ever had to raid your retirement savings during a financial emergency? Or have you been tempted, but found another way? Share with us!
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