NEW YORK (CNNfn) - Retirement may seem a long way off when you're in your 20s, and it may be tempting to dip into your long-term savings for short-term needs.|
In response to a reader's question, Frank Armstrong III, a certified financial planner from Miami, and the president of Managed Account Services Inc., said you should dip into your nest egg only as a last resort.
Ask the experts a question
I'm 26 years old. My spouse and I have approximately $17,000 in profit sharing and $9,000 in a 401(k) account. We also have an $8,000 credit card debt that we are paying $400 a month to pay off. I am thinking about leaving the company and cashing out the profit sharing account, paying off the credit card debt, and putting $2,000 into an IRA. Then we can put that $400 a month into a savings account or bump up the 401(k) allocation. Can you point me in the right direction?
You are very fortunate to have accumulated so much in your retirement accounts at such a young age. It would be a shame to blow it.
First, let's assume that you rolled over the entire account to an IRA when you changed jobs. Your $26,000 would grow to $412,440.42 by the time you are 55, or $664,239.42 at age 60, or $1,069,764.22 at age 65. We assume a conservative rate of 10 percent. That's a great example of the power of tax-free compounding over long time periods.
Leaving the account intact is exactly what the tax laws are trying to encourage. That way the rest of us won't have to support you on welfare when you reach retirement age. So, the government builds in some pretty strong penalties to try to prevent systematic dissipation of retirement savings when employees change jobs. After all, they gave you a big tax advantage when they let your employer deposit it into an account for you without paying any tax on it.
So, let's look at what happens if you withdraw some or all of it. Assume a $10,000 withdrawal. Right off the bat your employer is required to withhold 20 percent. You get a check for $8,000. But, it gets worse. When tax time rolls around next year, the $10,000 is taxed at ordinary income tax rates. If you are in the 28 percent bracket, that means $2,800 tax due. Then, of course, there is a 10 percent penalty tax of $1,000. Total tax: $3,800. Net to you: only $6,200.
After you get the $8,000 distribution from your employer, if you changed your mind and decided to roll over the $10,000 within the 60-day rollover period, you would only have $8,000 in your pocket. (Remember the 20 percent withholding?) So, now you would have to come up with the additional $2,000 to make the rollover. If you couldn't, then the missing $2,000 is subject to the tax and penalty.
Assuming that you came up with the missing funds from another source, and that you rolled the entire amount over, when you file next year you can recover the $2,000. In the meantime you have made a $2,000 loan to Uncle Sam.
Retirement funds are "sacred money." You should consider them a source of last resort. I would tap into them only to avoid starvation or something equally horrible. It would be a shame to deplete them to pay off a credit card balance. As I have tried to illustrate above, the trade-off is pretty unfavorable.
But, consumer debt is ugly! Interest rates are obscenely high, and they are not even tax deductible. You should make every effort to get it under control. It is possible to consider a life on somewhat less than 100 percent of your net income. Even if you never want to retire, at some point in your life you will want to be in a "work optional" status.
To clean up your credit card debt, you might consider temporarily suspending contributions to the 401(k). Then you could pay the cards off. Later you can use the 401(k) "catch up" procedures to fully participate in the advantages of your retirement plans and make up for your lost contributions.
Remember, a tax advantage is a terrible thing to waste!