Your employer 401(k) plan is a valuable tool in your arsenal for ensuring your future self will have assets available in retirement. The benefit of deferring part of your current income over a long period of time has allowed many individuals to retire more comfortably over the years. That said, many will be tempted to short-circuit the compounding process by tapping into their 401(k) prematurely. While there may be times when unforeseen events justify this, consider the following unintended consequences as a warning before robbing future you of a fuller retirement.
Tax Consequences
One of the most significant drawbacks of withdrawing funds from your 401(k) prematurely is the substantial tax penalties you’ll incur. If you withdraw from your 401(k) before the age of 59½, you’ll generally face a 10% early withdrawal penalty in addition to regular income taxes on the pretax portion of the withdrawn amount. This can erode a significant portion of your savings, making it an expensive option when compared to pulling cash from a savings account.
Lost Compound Growth
The great Albert Einstein once said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Your 401(k) is designed to grow over time, thanks to the power of compounded gains on your invested assets. When you withdraw money from your 401(k), you not only lose the principal amount but also completely stop the process of potential growth and investment gains that money could have generated over the years. Consider a distribution of $10,000 from a 401(k) plan. At a 7% assumed annual rate of return, this distribution over 30 years would have cost you $81,165 in forgone investment return! This lost growth can significantly impact your retirement nest egg in the long run.
Reduced Retirement Income
If you plan to live a retirement of abundance, it is crucial to not let current wants deplete your nest egg. Every dollar you withdraw prematurely from your 401(k) is a dollar less you’ll have in retirement. Relying solely on Social Security for retirement will likely cover only basic living expenses in retirement. By leaving your 401(k) funds untouched, you’re ensuring a retirement income that allows you to live more of the life you wish to and provides you with more options for lifestyle and care.
Difficulty Replenishing Funds
Once you’ve withdrawn funds from your 401(k), it can be challenging to replace them. You’ll lose valuable investment returns in the market, and catching up on your retirement savings will require higher contributions to make up for lost time. Considering the behavioral effects, it often becomes easier to justify future distributions from your retirement plan. The more you can view your retirement dollars as “off limits” for current expenses the better your future self will be.
While your 401(k) may represent a tempting source of funds to pay for current wants, it’s crucial to understand the long-term consequences of pulling money from your retirement savings. The combination of tax penalties, lost compound growth, and reduced retirement income can significantly impact your financial future. Instead of resorting to early withdrawals, consider alternative options like emergency savings, budget adjustments, or seeking financial advice to navigate your financial challenges without sacrificing your retirement security. Your future self will thank you for preserving your 401(k) for its intended purpose: a comfortable and financially secure retirement.
If you’d like to talk with an expert to create a plan for your money, schedule a meeting with the sales-free financial planners at Francis today.
