It’s been a tough couple days, weeks, months..years at the office or home. You’ve been beaten down, stressed out and just unappreciated so you’re finally fed up with it all. What do you do?
I know! You have to treat yourself; get away somewhere, anywhere.
But where? How about Indonesia, that sounds exotic. Sweet!
Put the entire trip on the credit card; airfare, accommodations, food, booze and all other Indonesian-esque (yeah that’s a word) activities. You name it, it’s charged on the card. After all, you deserve it.
Two Weeks Later…
The trip was an absolute success. You return home re-energized, tan and feel like a completely new person who’s ready to take on the world. That is until you see your credit card bill…
And Then Reality Sets In
$10,000! But what, when, how? Those Mai Tais must have hit you a little harder than you initially thought (both in the pocketbook and in your head).
The interest rate on that credit card is close to 20 percent! This credit card has to get paid so you don’t have to make those insane interest payments. But where can you quickly get $10,000 to pay it off. Think…
Aha! You can just take it out of your 401k. After all, you have $10,000 in there which can immediately get rid of the debt. Once the credit card debt is paid off you’ll be able to start contributing back to the 401k again. Before you know it there will be $10,000 back in your account without that pesky credit card debt weighing you down.
And Then Reality Sets In… Again
That sounds all fine and dandy on paper but here’s the problem. We’re not simply talking about $10,000 out of your 401k. In fact, we are talking a whole lot more than that, especially if you’re under 59 ½.
I call this, the Early Withdrawal from Retirement Accounts Funnel of Despair (catchy right?) because; as you will see, your $10,000 withdrawal quickly gets smaller and smaller as we progress. Let me explain:
1. Income tax on the money
It all starts with paying income tax on what is taken out. Remember that in a regular 401k Plan all the money you save in the plan is tax-deferred, meaning that you haven’t paid taxes on it yet. So when you take the money out of that plan, the Government is going to want theirs, which can be a fairly hefty amount.
Let’s assume that you make around $80,000 a year which would put you roughly in the 25% Federal Tax Bracket and 9.0% in your State’s Tax Bracket.
This means that when you take that $10,000 out of your 401k, you must pay $2,500 in Federal Income Tax and $900 to your State.
Not quite what you wanted to hear when you’re trying to pay off $10,000 worth of debt is it? But it’s all good. Paying off $6,600 of the credit card debt is definitely a step in the right direction and better than nothing.
Well hang on a second, Uncle Sam isn’t quite done taking his share yet…
2. 10% early withdrawal penalty
Let us not forget the 10% off the top of the money you take out of your 401k because you’re not 59 ½. The very instant that the $10,000 is removed from your 401k, Uncle Sam hits your money with a $1,000 penalty. Simply taking the money out to pay off the credit card debt turns your hard-earned $10,000 into $9,000.
Slowly but surely it becomes obvious that touching $10,000 before you turn 59 ½ in a retirement account is like a disappearing magic trick that quickly makes your money vanish.
The Early Withdrawal from Retirement Accounts Funnel of Despair
Well, congratulations I guess? After taking out your entire 401k to pay off $10,000 worth of debt including penalties and income taxes you can pay off a little more than half of what you owe.
As you can see, taking an early withdrawal from your retirement plan can have enormous unforeseen tax consequences. Yet it is not just taxes and penalties that will ultimately cost you.
This is the aspect of taking money out of retirement accounts that hurts you the most or any investment/savings account for that matter. When you take that $10,000 out of the market you may be sacrificing much more than penalties and taxes. You are sacrificing future growth potential.
The Rule of 72
In the investing world, the Rule of 72 is a shortcut way to figure out how long it would take your money to double given a specific rate of return. All you do is divide 72 by your annual rate of return. Easy enough right?
For our example here are our assumptions illustrating the Rule of 72:
- You are 25 years old
- You have $10,000
- You receive an average annual return of 8 percent
When we divide our 8% annual rate of return into 72, we get the 9. This 9 represents the number of years it will take for our $10,000 to double.
So if I take a 25 year old who currently has $10,000, according to the Rule of 72, when they turn thirty-four their $10,000 will compound to $20,000. When they turn forty-three their $20,000 will be $40,000 and when they turn fifty-two their $40,000 will be $80,000. So on and so forth until eternity or at least until you want to use the money down the road hopefully when your 59 ½ or older.
*This is a hypothetical illustration and is not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. Individual investor’s results will vary.
By the time you reach 70, that measly $10,000 would have grown to $320,000 given the Rule of 72 and our stated assumptions.
When you sacrifice $10,000 today to pay off a short-term expense (in this case credit card debt), it is more than simply the $10,000 you are parting ways with. It is the compounding potential and future value that $10,000 has the ability to grow into.
So What’s Your Point Jake?
Taking $10,000 out of your 401k before 59 ½ to pay off high interest credit card debt may sound like a good idea but there are taxes and penalties that can quickly eat away at your $10,000. Not to mention taking into account the time value of money that could potentially have allowed for this money to grow over the long run.
My point is this. The next time you consider using a retirement account to pay for debt or any short-term expense consider all of the implications. Concentrate on monthly savings and budgeting to tackle short-term expenses (including debt) before looking to your retirement accounts as a safety net.
Any opinions are those of Jacob Dahlstrum and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.