Emergencies come up in everyone’s life, and no matter how prepared we think we are, they often catch us by surprise. Most people understand that they should have an emergency fund of between three to six months worth of living expenses saved, but that is a tall order for many people especially in today’s economy. Now, more and more people are reaching into their retirement accounts such as a Roth IRA, 401(k), or Traditional IRA in order to fund emergencies. While this can provide you with a potentially large pool of money to tap into, an early withdraw from your retirement account should be used only as a last resort.
There Are Many Types Of Retirement Accounts To Tap Into
You have many different types of retirement accounts that you can tap into if you have an emergency. Many people have access to a 401k retirement account through their employer in addition to Traditional and Roth IRAs that they also may have separately. Your retirement funds offer you a large pool of cash to tap into during an emergency or for other big ticket items that have not be adequately saved for such as college education, buying a home, or starting a business. An early withdrawal can help you escape from having to borrow the money needed in order to pay for these items.
Borrowing costs can be high with financial institutions charging high interest rates. This is especially true for those with poor credit who may not have access to traditional lending options or who cannot borrow money at a low interest rate. Withdrawing the money from your retirement account may be a way to fund these items without the need for borrowing money from a third party that you will owe interest to.
The Pros Of An Early Withdrawal From Your Roth IRA Accounts
A Roth IRA offers investors a unique tool to withdraw funds from in a pinch. If your funds have been invested for more than five years, you may withdraw your contributions from a Roth IRA without having to pay any tax penalties on the withdrawal. Because you invest your original contributions after already paying taxes on that investment, Roth IRAs provide investors with a option of withdrawing those contributions tax free if needed.
You would only be responsible for the 10% early withdrawal penalty if you were under the age of 59 1/2 years-old and you ended up withdrawing investment earnings from your Roth IRA on top of the contributions. While you still may owe an early withdrawal penalty, the benefit of withdrawing your contributions without tax repercussions is a great benefit only provided to Roth IRA investors.
The Drawbacks Of An Early Withdrawal From Your Retirement Accounts
Early Withdrawal Penalties
In many cases, you may have to pay an early withdrawal penalty if you withdraw money from your retirement accounts. For example, if you withdraw money from your 401(k) retirement plan or from a Traditional IRA before you are 59 ½ years-old, you will not only have to pay tax on the money you withdraw at your normal tax rate, but you will also owe a 10% early withdraw penalty.
This can ultimately wipe out 40% or more from your retirement nest egg because of the early withdrawal. For example, if you withdrew $50,000 early from a Traditional IRA or 401k retirement plan, you could expect to lose $5,000 because of the 10% early withdrawal penalty and another $14,000 in taxes owed (assuming that you are in the 28% tax bracket). With a Roth IRA, you will not have to pay taxes on an early withdrawal of your contributions that you have invested in the Roth IRA because the money was already taxed before you invested it in the account. While you will still be hit with the same 10% early withdraw penalty if you withdraw earnings out of your account, you would only have to pay taxes on your accounts earnings or capital gains.
Loss Of Future Earnings Growth
The beauty of a Roth IRA and other retirement accounts is the power of compounding interest. If you withdraw money from your Roth IRA or retirement accounts early, that money will never be allowed to compound interest. Subsequently, that interest that you would have earned if you had left your money in the account will never earn interest as well either. To show you a quick example, let’s assume that you invested $5,000 every year for 20 years earning 8% annual rate of return. After those 20 years, your nest egg would have grown into $228,000.
If you never invested another dime into your nest egg and just let it compound for another 20 years, you would be sitting on $1.06 million. But, what would happen if you had taken a $20,000 early withdraw from your Roth IRA after that first 20 years? In the end, your nest egg would only have grown to $973,000. While $973,000 for retirement is nothing to sneeze at, it cost you approximately $93,000 in future earnings from compounding interest by taking that $20,000 early withdraw 20 years earlier.
When you are backed into a corner and have no other option, it may be give you a sense of comfort to fall back on an early withdraw from your retirement accounts such as a Roth IRA, 401(k), or Traditional IRA. But, these withdraws should be used as a funding of last resort. The cost of dipping into your retirement accounts can devastate your future earnings. Your retirement funds were not set up to be an emergency fund, and you should not use them in that way if at all possible.
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