Are You Worried About Money? Don't Make This One Big Mistake

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Americans are feeling stressed about money. A recent survey from the Federal Reserve Bank of Philadelphia found that as of April 2024, 36.8% Americans are concerned about making ends meet in the next six months. That's a big increase over one year ago, April 2023, when only 30.9% of respondents felt worried about money in that way.

If money is tight and your budget is stretched thin, you might be tempted to take cash out of your retirement savings early. Some people use their retirement accounts as an emergency savings fund. But beware: early withdrawals from retirement accounts can hurt you.

Let's look at why cash-strapped Americans should be careful when making early withdrawals from retirement accounts.

10% of Americans are raiding their retirement savings

According to Bloomberg analysis of the Fed's survey, during the past 12 months, 10.2% of Americans took money out of retirement savings early. This emergency money move was especially prevalent among higher earners -- 14.3% of people with incomes of $150,000 or more took money out of retirement accounts early. (Perhaps people with higher incomes are more likely to have well-funded retirement accounts in the first place.)

If your income isn't keeping up with your expenses, ideally you should use your emergency savings account first. But most Americans don't have a lot of cash in the bank. Only 45% of Americans can cover an unexpected $400 expense without using a credit card, according to The Motley Fool Ascent's research. A big car repair, home improvement project, or medical bill can easily eat up that amount of money.

Sometimes raiding your retirement account (by withdrawing cash early) is the best move for your personal finances. But there are potential consequences that you should be aware of before you take emergency cash from your 401(k), traditional IRA, or other retirement account.

Why you shouldn't take early withdrawals from retirement accounts

Most tax-advantaged retirement accounts, like 401(k) accounts and traditional IRAs, require you to keep the money invested until you reach age 59 1/2. At that point in your life, you're allowed to take money out (called "distributions") to help pay for your expenses in retirement.

But not everyone can wait to age 59 1/2. Life happens. You might have emergency expenses or financial setbacks that cause you to need that retirement account money sooner than you planned. But there are two big reasons why you should avoid taking retirement money out early.

Extra tax penalties

If you have to take early distributions from your 401(k), traditional IRA, or other qualified tax-advantaged retirement plan, you will have to pay income tax on that amount of money, and an extra 10% tax penalty.

So for example, if you're in the 22% federal income tax bracket, and you take $10,000 out of your retirement savings as an early distribution, you would owe a total of $3,200 of tax on that money. This is why taking early withdrawals from retirement accounts is a bad idea and should be avoided. The IRS gave you a nice upfront tax break on the money you put into these accounts, so it's going to make you pay extra tax on the money you take out.

Loss of future investment growth

Taking money out of a retirement account is not the same as taking cash out of a bank savings account. When you take money out of your 401(k) or IRA early, you likely have to sell stocks , bonds, or other assets that the money is invested in.

This can cause you to lose money in the short run, if you're forced to sell assets that have gone down in price during a market downturn. And if you don't quickly repay your retirement account, you might lose even more money in the long run by missing out on future growth of the investments you sold.

Ideally, you should leave your retirement savings invested for the long run. Using your retirement account as a short-term emergency piggy bank can hurt you in multiple ways, not just at tax time, but in your overall investment performance.

Exceptions to extra tax on early withdrawals from retirement accounts

Fortunately, there are some exceptions where the IRS lets you take an early distribution from your retirement account without owing 10% in extra tax penalties. The rules are slightly different based on the type of retirement account. But here are a few examples of when you can take early distributions from a 401(k) or IRA without penalty:

• Emergency expenses of up to $1,000 per calendar year
• Qualified birth or adoption expenses up to $5,000 per child
• Unreimbursed medical expenses greater than 7.5% of adjusted gross income (AGI)
• Disaster recovery distribution -- up to $22,000 for victims of federally declared disasters

For more details, check out the IRS website .

Bottom line

Unless it's an absolute emergency, don't take money out of your 401(k) or IRA. Try to leave that money alone and let it grow until you're 59 1/2 (or beyond). But if you end up in a cash crunch, before you take money out of your 401(k), IRA , or other tax-advantaged retirement accounts, see if you qualify to avoid the 10% tax penalty. And try to replenish your retirement savings as soon as possible, so your investments can grow for the future.

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