Written by Trent Hamm, The Simple Dollar is a popular personal finance blog that chronicle's one man's road back from overwhelming debt to financial security. Hamm declared the contents of the blog to be in the Public Domain in 2008 and available for sharing when attributed properly. We will share a couple of posts a week.
What mistake? According to the Arizona Star, more than 25% of Americans are raiding their 401(k)s to stay afloat.
The only way this even looks like a good idea at all is if you’re looking only at the very, very short term. If you look beyond that, making this move is pretty clearly worse than using a high-interest credit card to pay your bills. In fact, if we’re comparing disastrously bad financial moves, I’d actually prefer to use a credit card cash advance to pay a bill than pull money out of my 401(k) early.
Why is it so bad to tap into your 401(k) early? Let’s use this 401(k) early withdrawal calculator to see how big the disaster is.
Let’s make a few reasonable assumptions first.
First of all, let’s say we want to take $20,000 out of our 401(k). We’re in the 33%federal income tax bracket, and we pay 5% in state income taxes. We’re 45 years old and don’t plan on retiring for 20 years at least. If we left our money in there, we’d get an average of a 7% return each year until retirement – the long term return that Warren Buffett suggests people will get from the broad stock market.
On that $20,000, you’ll have to pay a $2,000 early withdrawal penalty, $6,600 in federal taxes, and an additional $1,000 in state taxes. Thus, out of the $20,000,you’ll only keep $10,400 of it. Between federal and state taxes, you’re going to lose just about half of your money instantly. Poof.
Let’s say that instead you left it there where it earns a 7% annual return. In twenty years, your investment will be worth $77,394. That’s the start of a pretty nice nest egg, one that will probably give you $3,000 or so a year take-home all throughout retirement.
So, just to get $10,400 now, you’re sacrificing $3,000 a year for years and years and years when you retire. That is an incredibly bad trade.
Then there’s the flip side of that coin.
Let’s assume the average person pulling money out of their 401(k) is making $50,000 a year. That’s a little higher than the average American salary, but many of the low-end salaries don’t have a 401(k) involved, so we’ll assume a bit higher average income.
If that person can find a way to come up with just 20% of their annual income to fix their financial situation, they don’t have to pillage their retirement.
Clean out your closet and sell the junk you don’t use. Write a grocery list when you go to the grocery store and stick to it. Even better, don’t go to the grocery store on an empty stomach. Have some friends over to your house instead of going out. Stop using your credit card for purchases and live off of cash so that you’re paying less credit card interest every month. Call up your creditors and negotiate a lower interest rate or a payment plan.
If you’ve been reading The Simple Dollar for long at all, you get the idea. Here’s a hundred more.
Fixing a short term problem by pillaging your long term savings is never a good idea. If you’re eyeing your retirement savings in order to keep your head above water or to enjoy some life “treat,” turn your eyes instead to the multitude of tools you already have in your life for coming up with some quick cash or trimming back your spending for a while.