Consider the Alternatives Before Tapping Your Retirement Savings

Thinking about withdrawing some money from your retirement savings account to buy that new car you've been admiring or treat yourself to a nice, long vacation? You may think, "I'll have time to make it up." Well, think again. The cost of withdrawing from a retirement savings plan can be much greater than people realize.

Meet Jeff. At the age of 30, Jeff begins contributing 8% of his salary to his company's savings plan. When he starts, his annual salary is $30,000 a year and he receives a 3% raise each year. Jeff puts money in for 30 years and earns about 8% each year on his investment.*

Let's say that after 10 years Jeff wants to buy a bigger house and decides to withdraw money from his savings plan to help with the down payment. His savings plan at that point is approximately $43,000. He thinks that taking out $10,000 can't hurt him that much in the long run; after all, he still has 20 years until retirement.

Up front, Jeff has to pay a 10% early-withdrawal penalty and 28% federal income tax on the money he withdraws. Right away, the $10,000 withdrawal has cost Jeff $3,800 ($1,000 + $2,800).*

Based on these assumptions, Jeff's account balance when he reaches retirement 20 years later would be about $360,000 before taxes. But what if he hadn't taken out the $10,000 when he was 40? The following chart shows that if Jeff hadn't touched his retirement savings, his account balance would have been more than $405,000. The long-term cost of the withdrawal was $45,000. Combined with the immediate cost of $3,800, that's a total cost of almost $50,000 for withdrawing just $10,000.

Always bear in mind that your retirement savings plan is intended to be a long-term investment meant to create added financial security and peace of mind when you retire. A loan from your retirement savings plan account can make sense if you have no other options available at the time and an important reason for withdrawing money.

If you're looking for tax relief and you qualify, consider an alternative like a home equity loan. Or with current interest rates so low, consult with your banker about a traditional loan, or tap into your personal savings. All of these solutions have an impact on your finances, but taking a loan from your retirement savings plan may come at a much greater cost at a time when you have a real need for the money.

Losing out on the benefit of compounding isn't the only way you can lose money by withdrawing from your retirement savings.

Depending on the type of account, if you're under age 59-1/2, you may have to pay the IRS an early-withdrawal penalty of 10%.

Plus, if the money in your plan was tax-deferred, you will have to pay taxes on the amount withdrawn at your current income tax rate. Sold at par, you may pay more or less than that, depending on its value at the time of purchase.