Retirement Accounts Are For Retirement, Not Everyday Spending

If you’re like many Americans with a 401(k), IRA, or other type of retirement account, the last few years of stock market gains may have sent your paper wealth soaring. There are more 401(k) millionaires in the United States today than ever before. But with the sums in retirement accounts piling up ever higher, and American households more indebted than ever, the temptation to dip into that money to pay for houses, cars, or everyday expenses grows as well.

More and more Americans, especially younger Americans, are dipping into their retirement accounts to pay for things, even just for discretionary spending. That’s a bad idea on a number of levels. For one thing, if you take a distribution from a retirement account before you turn 59½ and it’s not a qualified distribution (medical expenses, home purchase, educational expenses, etc.) then you’ll pay a 10% penalty on top of any taxes you owe. And by taking out money before you retire, you’ll penalize your future retired self and hamper your ability to save for retirement.

How Badly Does Tapping Into Your 401(k) Hurt You?

Ultimately the harmful effects of dipping into a retirement account are based on how much money you withdraw and how much longer you’re going to keep saving and investing. Taking out a little bit of money early on will hurt you, but you have a much longer time frame to continue investing so you can make things up later on. But pulling out money later in life, say mid-career, often means that you won’t be able to save enough in the future to make up that loss.

Let’s take the hypothetical example of someone who begins saving $6,000 a year at age 25 and invests that same amount every year until retirement at age 65. Let’s also assume an average annual growth rate of those investments of 7%. After 40 years that person would have nearly $1.28 million saved up.

Now let’s assume that at age 30 that person takes out $15,000 to pay for some sort of qualified expenses. That drops the account balance from around $36,000 to around $21,000. By age 65, that person only has $1.12 million in his account, about 13% less than if he hadn’t taken that early distribution.

How about a second scenario, this time with the person pulling out $40,000 at age 35 to make a down payment on a house. That drops the account balance from around $88,000 to around $48,000. By age 65, the account is only up to $971,000, or 24% less than it would have been.

Now look at a third scenario, in which the account holder pulls out $40,000 at age 40 to make a down payment on a house. The account balance here drops from around $160,000 to around $120,000, the lowest drop percentage-wise of all these scenarios. But because there are only 25 years to continue saving, the person’s account balance at age 65 is only $1.06 million, or 83% of what it would have been.

Single vs. Multiple Distributions

All of these scenarios illustrate the effects of a one-time early distribution on final retirement savings. But what happens when people start treating their retirement accounts like an ATM? Taking our example from above, let’s assume that the investor takes three different $5,000 distributions to pay for expenses, at ages 35, 38, and 41. At age 65 he has only about $1.14 million, or 90% of what he otherwise would have had. If those distributions increase to $8,000 each time, then at age 65 he only has $1.06 million, or 83% of what he would have had. A mere $24,000 in distributions has cost him over $200,000 of retirement savings.

That scenario isn’t far-fetched either, as nearly 60% of Americans between the ages of 18 and 34 have drawn on their retirement accounts. That’s double the percentage of just three years ago. Even more concerning, over half of those people took out the money for non-qualified reasons, such as losing a job, making a large purchase, or taking a vacation. In comparison, only 8% of those over age 55 tapped into their retirement accounts for similar reasons.

Time to Start Saving

With more and more Americans treating their retirement accounts like an ATM, that will have a profound impact on the financial health and well-being of many American households. Borrowing from themselves in the short term, those households will find themselves in a significantly weaker financial position when it comes time to retire.

It’s incredibly important to discipline yourself not to think of your 401(k) account as a piggy bank or ATM that you can rely on, even in emergencies. You really need to save up 3-6 months worth of expenses in a bank account so that you have liquid funds available to help you out, then you can safely push your 401(k) to the back of your brain.

Aside from occasional asset reallocation, such as moving a portion of your retirement assets into a gold IRA when stock markets look set to plunge, your 401(k) or IRA should be a passive account that continues to accrue value and grow in size. That’s the only way that you’ll be able to guarantee a chance at a safe and comfortable retirement.