Taxes + Penalty = Forfeiting Nearly Half of Your Money
It's tempting to cash out your retirement savings in the midst of a short-term cash crunch. After all, you worked hard to save that money. And if you've had a recent job change, you likely know how much you have down to the penny. While the money may seem to beckon you to take it now, let me introduce four important reasons to ignore that call.
More and more people are dipping into their retirement accounts before they retire. According to recent research , 37% of people have taken money out of an IRA or 401(k) before age 59½—the age you can make a withdrawal without a penalty.
That represents an increase of nearly 30% since 2015. For those under age 34, the likelihood is even higher, with 60% reporting that they've already taken some cash.
Why are people cashing out ? Medical emergencies top the list and losing a job ranked third, but other reasons were named, too:
Just because cashing out has become more popular, doesn't mean it's the best plan.
Your retirement account grows tax-deferred until you withdraw. Taking the cash could mean a higher tax bill. The withdrawal amount is added to your normal income, potentially putting you in a higher tax bracket.
Depending on which bracket you're in, it could mean owing from 10-37% on your withdrawal. You could also owe state and local taxes on the amount. All of these will become a reality when it's time to file your taxes.
On top of your tax bill, the IRS imposes a 10% penalty if you are under age 59½. There are some exceptions, such as in the incident of a death or disability. However, the penalty is generally taken right off the top. Combined with your tax bill, you could forego nearly half of your savings.
Taxes + Penalty = Forfeiting Nearly Half of Your Money
This example assumes the following: A hypothetical 24% federal marginal income tax rate, a hypothetical 7% state income tax, and a standard 10% penalty for early withdrawal. This example is for illustrative purposes only. Please note that the 10% early withdrawal penalty does not apply to distributions made to an employee after separation from service during or after the year they turn age 55.
Taxes and penalties are current losses. But the biggest hit may be from missed growth opportunities for your financial future. Withdrawing now means you'll miss out on earnings you could have made over several years.
Below is an example that shows the money you could potentially forfeit if $10,000 is withdrawn from a retirement account today versus keeping it invested for 25 years—or keeping it invested and adding to it.
You withdrawal the money now and are under the age of 59½.
You keep the money invested for 20 years.
You keep the money invested and you add $100 a month for 25 years.
The last reason to rethink tapping into your retirement account is the potential sacrifices you may need to make in the future. Less money could mean working longer than you'd hope to or rethinking how you want to live. Even if you're able to adjust to a different lifestyle, you may not be able to eliminate regret from not saving more or the worry about whether you'll have enough money to last.
REGRET AND WORRY ARE REAL FOR THOSE FACING RETIREMENT
Source: On the Same Page? Study: 7th Annual survey of plan participants includes sponsor perspectives. American Century Investments® 2019.
If you took money from a retirement account when you left a job, you can put that amount back into a qualified retirement account—such as an IRA or new employer's 401(k)—within 60 days. This is known as an indirect rollover and will save you from paying taxes on it or the early withdrawal penalty.
You can apply this rollover rule to an IRA, too, as long as you put the money back during the 60-day window. It's kind of like "borrowing" on a very short-term from your IRA, although there are strict IRS rules that could result in you losing your IRA's tax benefits. However, if you do redeposit the money in 60 days, you can avoid the taxes and penalties. Since the IRS considers this a rollover, you are only allowed one during a 12-month period.
Before considering taking money from a retirement account, consult a financial professional or tax advisor to understand the full implications to your taxes and your account.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
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