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When a big expense comes up, it can be tempting to turn to your retirement account for extra cash. If you have the money to cover a home remodel or a child’s college tuition in your workplace 401(k), why not?
But dipping into your 401(k) early, or cashing it out altogether, costs more than you might imagine. Not only do you get hit with taxes and withdrawal penalties, you miss out on the long-term benefit of compound growth.
Any investing pro will tell you it pays to keep your hands off your 401(k) until you retire. Take a look at the stories below to see the consequences of covering big life events with your 401(k) funds.
The $200,000 Sofa
A recent Fidelity study found that one in three 401(k) investors cashed out their retirement accounts before reaching retirement. The most common reason? Changing jobs.
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If you don’t have a ton of cash saved up in your 401(k) when you leave a job, you might just want to take your cash and run. But even a small cash-out can have a big 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 his $4,500 401(k) to pay for his move and to furnish his new place. He really needs a new sofa. After all, it’s only $4,500, right?
Turns out, it’s even less. First of all, Uncle Sam keeps 25% for income taxes. Then Joe also gets penalized with a 10% early withdrawal fee, reducing his $4,500 to a mere $2,925.
And even worse, Joe will miss out on the long-term benefits of compound growth. If he had rolled his 401(k) into an IRA when he left his job instead, Joe’s account could have grown to over $200,000 over the next 40 years, and that’s without any other contributions. Talk about a pricey sofa!
Retirement or College Funding?
So maybe you’re not thinking about cashing out your whole 401(k), but you’ve considered dipping into it to cover a big expense, like your kid’s college tuition. Most 401(k) plans allow you to borrow up to 50% of your account’s value up to $50,000, so it’s a common place for parents to turn when they don’t have the money to pay for college expenses.
Let’s look at the consequences:
- To start with, you have to pay back the amount you take out in a loan with 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 your loan back within a certain time frame to avoid taxes and penalties.
- If you leave your job for any reason, the full loan balance is due within 60 days.
That’s a lot of negatives to consider. That’s why we always recommend that your retirement savings come first, even before funding your kid’s college.
Your child can go to college debt-free by choosing a school they can afford, working part time, and applying for scholarships. They will be okay. But you’ll depend on your retirement savings for basic life necessities. Prioritizing your retirement is not selfish. It’s a smart financial decision for your future.
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Prioritizing your retirement is not selfish. It’s a smart financial decision for your future.
The Million-Dollar Backyard
But what about home renovations? Take Paula, who at 35 already has $100,000 in her 401(k) account. She decides to give her outdoor space some love and borrows $50,000 from her 401(k) to fund a new backyard oasis, complete with a new patio, fireplace, and pristine landscaping.
It will 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? You may be surprised.
Paula could lose more than a million dollars.
Not only did she forfeit the compound growth that $50,000 would have earned, she missed out on eight years of contributing to her 401(k) while she was paying back the loan. Ouch!
Stick With Your Plan
According to the National Bureau of Economic Research, 37% of active 401(k) plan participants borrowed against their 401(k) over a five-year span. But just because it’s common doesn’t mean it’s smart.
Life has a way of throwing the unexpected at you. That’s why it’s always a good idea to have an investing pro you trust in your corner. The right investing pro will help you make smart decisions about your future and stick with your investments for the long term.