Would you raid your retirement accounts to make a down payment on a home? Recently, I read an article about millennials taking an early withdrawal from their 401k to fund a downpayment on a home. The article went on to say that most millennials who took an early withdrawal were dissatisfied with their choice.
In fact, 2 out of 3 millennial homeowners said they had regrets about purchasing their home. They stated they felt stretched financially by the costs of maintaining a home. Overall, it seems that many millennial homeowners did not think through their purchase as well as they should have.
I believe one of the biggest mistakes you can make in purchasing a home or paying off debt, is to withdraw money early from your retirement accounts. It has HUGE consequences that most don't take into account before they do it. In this article I'll show you why making an early withdrawal from your 401k (or other retirement accounts) to pay off debt is a terrible idea.
Should You Use a 401k Early Withdrawal?
So, when you need a large chunk of money to put a down payment on a house or pay off some debt, there are many ways to approach it. But I know from experience and basic human nature, most of us want the easy way out.
When you know you have a pile of money in your retirement account just sitting there, it's extremely tempting to use it.
At first glance using your 401k might seem like a good idea.
You tell yourself “I’ve got $20,000 in my 401k and I owe $20,000 in credit card and other debt. I can be debt free if I just use that money that’s just sitting there doing nothing. Paying down debt and not having to pay all that interest would be a good thing, right?”
Or when it comes to buying a house you might say “It'll take me years to save up for a down payment! I'll just use this pile of money in my retirement accounts and pay it back later. That's a good decision, right?”
If You Withdraw Early from Your 401k, There Are Consequences
Unfortunately, too many people don't think about the consequences of draining their retirement accounts. And if they do, very few will actually run the numbers to fully understand the consequences of an early withdrawal.
First, there are immediate consequences to cashing out 401k money. Just because you have $20K in a 401k account doesn’t mean you’ll get $20K if you cash out. When you take cash out of a 401k, IRA, etc., you have to pay taxes on that money at your normal tax rate. So if you are in the 25% tax bracket (middle class), then 25% of your $20,000 automatically comes off the top. Now you have $15,000 to pay off your debt or fund a down payment.
But wait! Retirement plan laws dictate that if you withdraw money before age 59 1/2 you have to pay a 10% penalty ($20,000 x 10%= $2,000) on top of the taxes you already paid. Now you have just $13,000 left out of your $20,000 withdrawal.
At this point, you have automatically lost 35% of your money before you could even put it to work! This is a terrible way to manage your finances.
Early Withdrawal Sabotages Your Future
The next thing you should understand when you withdraw money early from a retirement plan, is that you sabotage your future security to to satisfy a present need. When you take that money out, it won’t stay put and grow exponentially as the market rises over time.
So not only do you lose 35% of your money by withdrawing early, you actually lost almost $150,000 of future earnings ($20,000 x 10% x 20 years).
So now because you didn't think clearly, your early withdrawal cost you $150,000 to fix a $20,000 need! This is the point where you form a right angle with your thumb and forefinger and raise it to your forehead, you are officially a loser, financially speaking.
What About a 401k Loan?
There is another method you can use to take money out of your 401k. It's called a 401k Loan.
On the surface it sounds like an ideal situation. With a 401k loan:
- You don't pay any taxes on the loan.
- There is no 10% penalty.
- You can borrow up to 50% of your account balance, up to $50,000.
- You get up to 5 years to pay off the loan.
- The loan is usually at a lower interest rate than credit cards or other high interest loans.
Winner, winner, chicken dinner! This sounds like a no brainer, right? You borrow money from yourself and pay it back with interest over time- sounds like a great deal!
Not so fast.
Consequences of a 401k Loan
There is a problem with using a 401k loan, though. Taking that money out of your retirement account means it doesn't have the opportunity to grow through investing.
I know what you're thinking. The money DOES grow because you're paying yourself back with interest over time. So technically, yes, your money is making money and growing.
But think about this- who would you rather be paying interest into your 401k, you or the stock market?
I know I would much rather have other people (the market) growing my money for me instead of doing it myself.
It's a serious consequence of a 401k loan most people don't think about. But it's a real problem if you want to grow your little nestegg into a full blown retirement someday!
Early Withdrawals Don't Solve Your Problem
When it comes down to it, withdrawing money early from your 401k causes more problems than it solves. If you're using the money to pay off debt, it doesn't cause you to change the habits that got you into debt in the first place.
It simply acts as a Band-Aid to help the situation for a season. If you don't change behaviors with money, you will end up back in debt once again.
If you're using the money to fund a down payment on a house, that doesn't solve your problem either. Part of owning a house is about being financially solvent enough to afford homeownership.
If you're robbing your 401k to make a down payment because you can't save up the money for it, you probably don't need to buy a house until you can. You may need to change your spending habits or find ways to increase your income instead of robbing Peter to pay Paul.
Below you'll find some of my best resources to help with that.
Question: Have you ever made an early withdrawal or taken a loan from your 401k? What was your experience? Leave a comment and tell us about it.