Americans lose $5.7 billion each year to 401(k) and IRA early withdrawal fees—here's where that money goes
Savings vehicles such as 401(k)s and individual retirement accounts may be some of the best tools Americans have to help save for the future. But if you need to tap into those dollars before you retire, it will cost you.
Currently, Americans have about $5.9 trillion invested in employer-sponsored 401(k) plans, according to the Investment Company Institute. That's about 19% of the $30.1 trillion in total savings currently held in all types of retirement accounts within the U.S.
If you need to access those funds before age 59½, you generally have to pay a 10% penalty on any amount you take. The exceptions to that rule include education expenses, buying a home for the first time, incurring massive medical debts or being ordered by a court to provide alimony or child support.
Additionally, with the recently passed SECURE Act, new parents will be able to take $5,000 penalty-free from retirement accounts once regulators and employers provide guidance. Some retirement plans also allow withdrawals when experiencing a financial hardship, but about 15% of 401(k) plans do not.
Here's a look at what happens when do you opt to take funds out of your retirement account early.
The cost of early withdrawals
If you're trying to pay off debt or need funds to start a business before you're 59½ and you decide to dip into your retirement accounts to make up the difference, you'll face paying a 10% penalty plus taxes.
Normally, the IRS requires plan providers to withhold 20% of any withdrawal for taxes, since the money you contribute to a 401(k) is taken out of your paycheck before taxes are applied. If you take out $1,000, you'll only get about $800 right away, assuming you don't have to pay an additional 10% early withdrawal penalty.
Despite the name, the early withdrawal penalty goes to the same place as the taxes: the IRS. "It's a tax, even though we call it a penalty, and gets paid to the IRS," Christine Benz, Morningstar's director of personal finance, tells CNBC Make It.
The IRS earned roughly $5.7 billion in these penalties from qualified retirement plans in 2017, the latest year that the agency has made data available. These taxes generally only apply to distributions taken prior to 59½ that do not fall under allowed exceptions. That means Americans took out roughly $57 billion in early distributions that year that were subject to penalties, according to CNBC Make It's calculations.
On an individual level, the IRS received about 5.1 million returns that reported paying the withdrawal penalty tax in 2017, which means the average amount paid was about $1,107 per return. That means people are taking out just over $11,000 from their retirement accounts, on average, for non-exempt uses.
But raiding your retirement account has consequences beyond just the taxes and penalties you'll pay upfront. There's also an opportunity cost to using your retirement savings early. A $5,000 balance today could be worth $57,900 in 35 years, assuming a 7% annual rate of return. Many times, every dollar counts when attempting to save for retirement.
Where to turn if you need funds
At the end of the day, many Americans are already falling short when it comes to saving enough for retirement, so pulling funds out is generally not a good option.
If you need cash and don't have any emergency savings to use, consider taking a 401(k) loan. These loans are not taxed, but you can only take up to half of your vested account balance — and not more than $50,000, no matter how high your balance. All loans need to be repaid within five years with interest (this is set by your plan, based on the prime rate, which is currently about 4.75%), or you'll be hit with taxes.
You could also apply for a personal loan from your bank, which is generally used to consolidate debt or make a big purchase. The average interest rate for a two-year personal loan was about 10.2% in November 2019, according to the latest data from the Federal Reserve.
Keep in mind that the rate depends on both your credit and on the length of the loan, as shorter loans tend to have lower APRs. If you have bad credit, you may be facing an interest rate of up to 36%.
If neither of those options are worthwhile, you could also tap into a Roth IRA if you have one. With these accounts, you can withdraw any money you've invested at any time, without taxes or penalties. But again, keep in mind that there's an opportunity cost to using that money.
Even if you do need to take a withdrawal to cover your expenses, make a plan for next time. Even $5 or $10 a week can add up over time when you're trying to build an emergency savings fund.
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