While drafting a blog post on passage of the SECURE Act, I felt compelled to discourage people from making “early withdrawals” from their retirement accounts. Rather than hijack my SECURE post, I thought I’d devote a separate post to cautioning against early withdrawals.
An early withdrawal happens when a retirement accountholder withdraws money from his or her account (IRA, 401(k), 403(b), etc.) prior to reaching age 59.5. Congress gave retirement accounts significant income tax advantages to encourage people to save long-term and specifically for retirement. It (Congress) does not want you to get all those tax benefits, but then use your account for non-retirement purposes. Therefore, most withdrawals made before the accountholder is 59.5 years old are subject to the “early withdrawal” penalty: an additional 10% tax paid on top of the income tax already due upon withdrawal. For example, if $30,000 was withdrawn, in addition to income tax owed on that $30,000, the taxpayer also would owe a penalty of $3,000.
While the 10% penalty is bad enough, thinking about the costs of an early withdrawal only in terms of the early withdrawal penalty misses an important part of the story. Early withdrawers lose in another way: the withdrawn money doesn’t continue to grow in their retirement accounts. It’s hard to conceptualize this cost without calculating it, but if you do, you’ll find it’s quite high.
For example, today I went to TIAA’s online early withdrawal calculator (there are others online; search for “early withdrawal calculator” to find them). I entered in the following hypothetical information:
Amount of withdrawal: $40,000 (I am imagining a family who needs a minivan after the birth of their third child)
Reason for withdrawal: Other (this is to make sure the early withdrawal penalty applied. There are some exceptions to the penalty)
Planned retirement age: 67
Date of birth: 1/1/1987
Annual rate of return on retirement investments: 4%
Current federal income tax rate: 12% (For taxes due April 15, 2020, this is the top bracket applicable for single people with taxable income $9,701 to $39,475, and for married filing jointlies with taxable income of $19,401 to $78,950.)
Current annual salary: $50,000
The results show the cost of the missed opportunity to let that money grow in the account:
Early withdrawal penalty: $4,000
[Income] Taxes: $4,800
Net amount after penalty and taxes: $31,200 [$40,000 minus $8,800]
Loss of potential asset growth: $111,773
Potential future value at retirement: $151,773
By taking a net distribution of $31,200 at age 33, this accountholder is foregoing having $151,773 in the bank at age 67. Those lost savings would have offered him or her a lot of flexibility and resilience at retirement. And, the earlier you make the withdrawal, the more you miss out on the value of that tax-deferred growth.
I’m human. Like everyone else, our family has had times of financial hardship and challenge. I know it’s awfully tempting to see your retirement account as a big pool of untapped money you can use as an alternative to taking a loan. However, the costs are prohibitive in all but the worst circumstances. It’s better to tighten one’s belt – a lot, if necessary – in order to leave one’s retirement accounts intact. If you’re able to follow this advice, you will thank yourself later.