Building Wealth A month ago, most Americans didn't know Tim Walz...
But since he was named as Kamala Harris' running mate, the Minnesota governor has been all over the news. And that includes a deep dive into his finances.
A few days ago, we learned that he'd made an all-too-common mistake...
Walz robbed his own retirement.
Reportedly, the Democratic vice-presidential nominee took $135,000 from a retirement plan last year to pay for his daughter's college expenses.
Walz isn't alone in dipping into his nest egg...
A report from Vanguard found that 3.6% of the investment group's 5 million 401(k) accounts took early withdrawals in 2023. That's up from 2.8% in 2022.
There's an old adage that says you can take a loan for education, but not for retirement. I (Laura Bente) agree fully.
Some parents might argue that they'd rather give their kids a head start for a solid financial future and not burden them with debt. But they'll likely pay for that gift in the future.
While your children have years to pay off a loan, if you're near retirement, you won't have years to earn that money back. And that could cause you to make difficult decisions in retirement.
It's true that while lots of our expenses will decrease in retirement – like no longer having a mortgage, perhaps – there's one expense that sees a huge increase. A report from Fidelity estimates that a 65-year-old will need $165,000 in retirement just for medical expenses.
Sometimes life doesn't give you any other option... But if you can avoid it, you don't want to take an early withdrawal from your 401(k) or similar retirement account. As I'll explain, it will cost more than just the amount you need to spend...
A popular type of early 401(k) withdrawal is a hardship withdrawal. When you want to make a hardship withdrawal, the first step is proving to your employer that you have an "immediate and heavy financial need." This covers expenses like medical bills or paying housing costs to avoid eviction. Once your employer confirms you qualify, you'll get the specific amount you need, plus any extra to cover the taxes you'll owe.
And that amount can be a big deal...
If you're younger than 59-and-a-half years old, you'll owe a 10% early withdrawal penalty in most cases. Plus, you'll have to pay federal and (if applicable) state income taxes on your withdrawal.
Let's say you need money for medical care and you don't have any other funds available to cover this cost, so you decide you need to take a $10,000 withdrawal. Your early withdrawal penalty costs you $1,000. If you're in the 22% federal tax bracket, this withdrawal costs you $2,200 in taxes. And if you pay 8% in state income tax, that's another $800.
In total, you're paying 40% of your withdrawal amount in taxes and fees. That means your $10,000 withdrawal only gives you $6,000.
That's a lot of money to throw away.
Plus, by withdrawing early, you lose the ability to compound your gains on that $10,000. That leaves you with an even bigger hole once you retire. If you're 50, that means you're losing 17 years of compounding returns, or about an extra $27,000 in your retirement account (assuming an 8% annual return).
Of course, there might be times when someone's financial need is so dire that this could be their only choice. And this could happen regardless of how much money they make. I've heard from people in low and high tax brackets who have found themselves in this position.
But proper planning now could help you avoid a future financial disaster like this.
If you look at your financial life as a house, an emergency fund should be the foundation. You want to make sure that in the event of an accident or job loss, you have the funds available to pay your expenses.
Most Americans don't have this first step in order. According to a Prudential survey, 50% of Americans have less than $500 in an emergency fund.
I've written before that contributing the maximum amount to your 401(k) – which is $23,000 for 2024 – is an essential part of your future financial freedom. But that shouldn't be at the expense of your wealth today.
Take time to look at your accounts to see where your money is going. If you're maxing out your contribution but you're not putting anything into an emergency fund, ask yourself if you can handle a crisis that hits before you retire.
Typically, financial planners recommend having about three to six months' worth of take-home pay in your emergency fund. We've even seen some recommendations for as much as nine months' worth of pay saved.
How much you need to keep depends on factors like your marital status, whether you have kids, your health, and your job stability. But aim for three months at minimum.
If you don't have that much in your emergency fund, you can temporarily lower your 401(k) contributions until you've beefed up your savings. Once your emergency fund is in good shape, you can up your 401(k) contribution anytime.
If you don't max out your 401(k) contribution but also don't think you have enough in your emergency fund, ask yourself the same question... Do you have at least three months' worth of your income set aside for an emergency?
If not, think about how you can start saving more. That might mean limiting nonessential expenses (like those five streaming services you're subscribed to) and putting that money toward savings... or temporarily reducing how much you're contributing to a retirement account.
But what can you do if you need money before your emergency fund is in place?
If you have a Roth IRA, that might be a better place to grab money from than your 401(k). Since you've already paid taxes on the money going into your Roth IRA, you don't owe taxes on the money you put in directly... only money you earned within the fund (like dividends, interest, or capital gains). You might also owe a 10% penalty depending on factors like your age and when you first started contributing to your Roth IRA. (You can read more about what counts as a qualified distribution here.)
But even if you have to pay income tax on a small portion of the withdrawal amount and the 10% penalty, it'll be significantly less than paying tax on the entire amount... like you would with the 401(k) hardship withdrawal.
Another option is a loan from your 401(k). If your employer allows loans, you could take up to 50% of your savings (up to $50,000). You won't have to pay taxes or a penalty fee, but you will have to pay the loan back – with interest – within five years. And if you leave your employer, you could have to pay the entire amount back sooner.
The specific terms vary by plan. But, like the Roth IRA distribution, it's a way to avoid paying a huge amount in taxes and penalties.
So before you raid your retirement plan to pay for your kid's college education, think about if your future retired self can actually afford that.
The best thing to do is to have a plan in place today for future needs. If you have young kids, start saving for their college expenses now. And always look into other ways to fund their education without robbing your retirement.
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- Something different: Oasis is getting back together.
Here's to our health, wealth, and a great retirement,
Laura Bente, CFP®
August 29, 2024