When an emergency or unexpected expense pops up, many people have a go-to strategy for coming up with the money to pay for it. Some turn to savings, others turn to credit and still others resort to borrowing from friends or family. Ideally, we'd all have enough wiggle room in our monthly budgets for an emergency expense, but sometimes we are forced to seek out other sources of cash.
One such source of funds that might seem tempting to tap into if you're up against a financial emergency (particularly a large one) is your retirement account. After all, retirement is years and years from now, right? While it might seem sensible to dig into your retirement savings if a financial need arises, this line of thinking couldn't be more dangerous.
Here are three reasons why you should not touch your retirement savings:
1. Your nest egg will take an immediate 10 percent hit.
If you withdraw from your 401(k) before the age of 59 1/2, you will face a 10 percent penalty fee on that withdrawal. There are certain circumstances that might exempt you from paying this penalty fee such as needing to pay medical expenses that exceed 7.5 percent of your adjusted gross income or needing to pay funds to a child, dependent or spouse by court order.
Before making a withdrawal, you'll want to check with your employer for more information about your plan to see if you're allowed, but generally a hardship withdrawal is allowed under certain circumstances. For example:
- Educational expenses (tuition, room and board, etc.)
- Preventing eviction or foreclosure on your home
- Purchasing a primary home
- Paying funeral costs for the burial of immediate family members
If you are allowed to make a withdrawal from your 401(k) account, then you need to take into consideration that when you do, there will be the additional 10 percent penalty fee that will be applied to the amount you withdraw. Therefore, you need to withdraw more money than just the expense you need covered.
2. You'll owe taxes on that withdrawal.
If you have a traditional individual retirement account or 401(k), congratulations! You've successfully dodged income taxes on the contributions you've made to either of those accounts. Well, so far. Eventually, you'll have to pay those taxes, and if you choose to tap into your retirement account before age 59 ½, you'll end up paying taxes much sooner than you expected.
In addition to that 10 percent fee, you'll be subject to paying your ordinary income tax on that amount. You would have owed taxes on your money in the end anyway, but had you waited to withdraw the money until retirement, it's likely you might have fallen in a lower bracket by that time and paid less in taxes. Plus, the tax amount that is subtracted on your withdrawal now could have been left in your account to compound and generate more money for your retirement.
3. You're jeopardizing your future wealth.
If you're not already convinced that using your retirement savings for quick cash is not your best approach to fill a shortage of funds, consider the effect it will have on your future wealth. The money you put aside for retirement today compounds over time, so if you pull money out you're impeding its ability to grow. By the time you retire, the money you withdrew could have made a considerable difference had it been left to compound and generate more money.
The bottom line: Using your retirement account to pay for anything other than retirement is an expensive long-term move, so resist the urge to dip into it until you're actually retired. It may seem tough now, but your self-control will pay off in the long run!
Neda Jafarzadeh is a financial analyst for NerdWallet, a website dedicated to helping consumers learn more about personal finance and how to invest their money effectively.