Not much causes my heart to race like when one of my clients asks me about pulling money from their retirement fund. Even though it seems like a simple endeavor with immediate rewards, it is actually a dangerous practice that can set you completely off track for retirement and cost you much more money in the long run than you might think.
Why is pulling from your retirement account such a bad idea?
For one, most people under the age of 59 ½ will immediately incur a 10% penalty. After that, you’ll have to pay interest on the money you pull out (usually around 20%, depending on your circumstances). That means the money you’re taking from your account is already whittling away.
As David Weliver of “Money Under 30” puts it, “Paying the 10 percent early withdrawal penalty is just dumb money—it’s equivalent to taking money you’ve earned and tossing it out the window.”
On top of that, there’s an even larger factor to consider: Compound interest.
Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on (find a discussion on compound interest on page 35 of my book, Self-Wealth). To put it another way, your retirement fund will earn interest…and then that new, larger sum will earn interest…and so on. So when you remove money from your retirement account—even for just a little while—you endanger the growth of the account.
Not to mention you’ll essentially be paying taxes on the money twice. When you repay a 401(k) loan, you do so with post-tax money. THEN, when you later withdraw those funds in retirement, you’ll pay taxes on the same money again.
Pulling against your retirement fund can also lead to high-risk spending behavior. A large portion of people who withdraw from their retirement fund do it multiple times. Also, many people see the extra money as false security and begin to focus less on their savings. As Doug Fisher, a Fidelity senior V.P. said in a statement, “Within five years of taking a loan, 40 percent of borrowers decrease their savings rate, and more than a third of those stop saving altogether.” Now that’s troubling!
There are many more reasons why pulling from a retirement fund can be disastrous. If you’re not convinced, ask a financial planner!
What can you do instead of drawing on your retirement fund? In my next blog post, I’ll go over some alternatives. Stay tuned!
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