Let’s be honest, we all run into a bad patch financially once in a while. We might lose our jobs, have extra expenses that we didn’t see coming, increased debt because of an illness or death in the family or sometimes we just plain overspend.
In these situations, our immediate impulse is to get out of the jam as quickly as possible and if we don’t have the money saved in an emergency fund one of the impulses that people may have is to raid their retirement accounts (e.g. your 401k, 403b, Roth IRA or IRA). This also sometimes happen when people switch jobs. Instead of rolling that money over to a rollover IRA at a company they take a check from their previous employer, spend the money, and then it becomes taxable income.
Unless it is a last resort and I mean the very last resort cashing out your retirement accounts or even taking a loan on your retirement accounts is a BAD idea. In fact, it is a TERRIBLE IDEA! Don’t DO IT! DO NOT CASH OUT or TAKE A LOAN ON YOUR RETIREMENT SAVINGS!
Now don’t get me wrong if you are starving and have absolutely no money, no prospects, etc then you might want to tap the financial accounts. However, even then you shouldn’t cash it all out, even with a small balance. And that dire scenario of you starving in the street, holding up a sign looking for work is, for the vast majority of us, not going to happen.
I know it can seem like a short-term solution, but it will do more damage in the long-run.
1) You lose the possibility of future gains. Albert Einstein supposedly said that the greatest force in the universe is compound interest. By cashing out and not rolling that money over to a new account or taking it out because your situation seems dire can cost you thousands of dollars in the future.
Think of it this way. If you have $10,000 in a retirement account and just left it alone, don’t add anything to it for the next 30 years. If it is in an average performing mutual fund (e.g. index fund). The average gain for the past 90 years has been at least 10%. In that 30 years you would have almost $175000. And that is if you did nothing! Think about if you added to it later on.
By cashing it out you deprive yourself of that money when you will need it most when you don’t want to work anymore.
2) You are essentially taking out a high interest loan. I know that cashing out the retirement account might seem like a good idea, but you are essentially taking out a high-interest loan to do so. So let’s say you have $10,000 in your retirement account and you liquidate all of it. You will automatically be penalized 10% if you are under the age of 59 1/2. So that gives you only $9000. Then that $9000 will be added to your income at the end of the year. So you will have to pay federal and state taxes on that money. Most likely at something like 15% (depending on your income), plus a state income tax, probably another 3-5%. So, your $10000 is actually only going to be about $7500. In other words, you took out essentially a 25% interest loan on your retirement savings and you now have nothing to show for it.
Does that sound smart to you? Hell, you would be better off taking out a credit card. The interest rates are typically lower.
3) You get out of the habit of saving. Now i certainly understand that if you are in a financial jam that you are not saving at that moment. However, if you have been saving in retirement, even just a little bit, that is a fantastic habit to get into. You cultivate a habit of saving, something far too many people don’t do. If you jump in and out of retirement savings and treat it like a piggy bank you lose that habit.
If you get in the habit of saving just a little bit you will have hundreds of thousands dollars at your disposal. If you just save a $100 a month and do that consistently, put it in a normal retirement vehicle by the time normal retirement age comes around you will have over $500,000. Now in 40 years that won’t be a lot, but it is better than nothing and most of us won’t just save $100 per month. We will save more. You deprive yourself of future monies. Monies, which are going to be extremely important in the future.
4) You might have to pay the money back right away. A common thing among some of my friends is that they take a loan out against their retirement savings. They justify it by saying they are paying themselves back and that is true to some extent. In some investment plans you can take out a loan against your 401k, typically up to $50,000. And then you have to pay back that loan over a certain period of time.
However, you pay back that money with after-tax dollars at a low-interest rate. You lose the gains that you would have if you would’ve left that money in the account and if you switch jobs you MUST pay back the loan IMMEDIATELY or it will count as income on your taxes. You will be hit with a 10% penalty and charged at your normal tax rate.
The Bottom Line
I am not saying that there aren’t extreme circumstances when cashing out a retirement account might be necessary. For example, if they are going to foreclose on your house that might be a scenario to do so. Or you are going to go through bankruptcy. However, those are extreme cases that most of will not deal with. However, many of us will be laid off, lose our jobs, or go through a rough financial patch. Even in those tough financial times I know it is tempting to touch the retirement funds, but I still say don’t do it. Don’t take out a loan and don’t cash them out. You will do more harm than good in the long-run.
And as someone who cashed out their IRA when they didn’t need too because I was impulsive and wanted to pay down some debt, which I didn’t really pay enough of it off, don’t make the same mistakes I did. I would have a lot more money right now if I hadn’t.