One of the positive affects of the recent recession was the general shift from spending to saving. The realization that not all jobs are secure made people think twice about how much they spend, resulting in a higher savings rate than our nation has seen in years. With more attention focused on saving money, it becomes necessary to understand where you should save and how to set savings goals. For most people, there are three types of savings goals: short-term, medium-term, and retirement savings.
Short-term and intermediate-term savings. Short and intermediate savings are generally used for emergency funds, a down payment on a large ticket item, and similar large expenses. For most short-term and intermediate purchases, a standard savings account or CD ladder should be enough to meet your savings goals. These are great places to save for near-term expenses because you have relatively easy access to your funds and they are FDIC insured. However, the opportunity for growth is almost non-existent when compared to saving in retirement accounts.
Long-term savings in retirement accounts. Retirement accounts offer many advantages for long-term investing, including a variety of growth opportunities and built in tax benefits. But retirement accounts should not be confused with a savings account. Withdrawing money from your retirement account before you are eligible can hurt you in more ways than you think.
Your retirement account is not a savings account. Despite the fact that retirement accounts are designed for long-term goals, it is relatively easy to access your money in the form of 401(k) loans and 401(k) hardship withdrawals. Just because you have the ability to access money in your retirement account doesn't mean you should. Consider the following three pitfalls associated with treating your retirement account as a savings account.
- Penalties and taxes. The IRS provides tax benefits to people who invest in retirement accounts, but the caveat is they will assess a 10 percent early withdrawal penalty if you withdraw your funds before you are eligible. In some cases you may have to pay taxes immediately upon withdrawal. If you plan on tapping your retirement account for reasons other than retirement, carefully consider how much it will cost you in taxes and penalties.
- Loss of growth opportunity. When you take money out of a retirement account, you immediately lose any growth opportunity for the amount you withdraw. Over time, this can end up costing you tens of thousands of dollars.
- Unprotected funds. Retirement accounts are exempt from most debt collection efforts. The majority of people who borrow from their retirement account do so as a result of a financial hardship or immediate need for cash. But once you remove money from your retirement account, your money becomes vulnerable to debt collection efforts.
As a general rule, retirement accounts should remain untouched whenever possible. There are few situations where the benefits of borrowing from a retirement account outweigh the drawbacks. To avoid this situation, make it a point to include short-term savings in your household budget. Your short-term savings will always be available for emergencies and won't hurt your long-term savings and retirement goals.