Don’t Volunteer to Pay Extra Taxes This Year

Today is April 15... tax day in normal times, but these are not normal times. Because of the pandemic, the federal government has pushed the deadline to July 15 this year.

Whenever you file, though, the one thing you should not do is volunteer to pay more taxes! Which is what people do when they tap their retirement accounts to pay down debt or cover emergencies.

As a general rule, when you take money out of a 401(k) or traditional IRA before you reach age 59.5, you have to transfer the money into another retirement account within 60 days. Otherwise, it’s considered an early withdrawal, and it puts you in a world of trouble.

To start, an early withdrawal is usually considered taxable income, so it’s subject to the regular old federal income tax. Plus, it could bump you into a higher tax bracket. So you may end up paying even more because of that.

Plus, there’s the 10% penalty—which is code for “another 10% tax.” That might not sound like a lot, but say you take a $40,000 early withdrawal. The penalty would “only” be $4,000, which is a lot of money to most people. Especially if you’re in some no-good situation where you’re considering an early withdrawal.

Read the Fine Print

Of course, there are a whole bunch of exceptions to the early withdrawal rules—ranging from certain unreimbursed medical expenses to total and permanent disability.

The CARES Act, which Congress recently passed to help relieve some of the financial strain brought on by the coronavirus shutdown, also allows for early withdrawals in many instances without the usual 10% penalty.

All the details of these exceptions, and the exceptions to the exceptions, are too endless to cover here. So, if you do make an early withdrawal—even though I urge you not to—please, at the very least, check in with your tax pro first. The last thing you want is to assume you qualify for an exception, only to find after the fact that you don’t.

Your Retirement Account Is for Retirement

Even without taxes and the 10% penalty, withdrawing money from your retirement account is almost never a good idea. Because here’s what happens—

If you’re using the money to pay down debt, the debt will come back. Why? Chances are you didn’t get into debt because of an emergency. Chances are it’s the result of overspending. Or poor choices about the big stuff, like the house you could never really afford, the student loans, etc.

If you pull from your retirement account to pay off debt, the habits that put you in debt will still be there. And eventually, you’ll dig yourself into another debt hole. That’s far worse than returning to square one, because now you’re in debt, but you have a lot less saved for retirement.

Remember, your retirement accounts are for retirement. If you want that money to be there in 20, 30, or 40 years, you can’t touch it. Not to pay off debt. And not to cover emergency expenses.

That’s what your emergency fund is for! We’ve talked about how much you need in your emergency fund a lot lately—enough to cover six months of living expenses or $10,000, whichever is greater. That’s the minimum, though.

I see no problem with stashing gross amounts of money into an emergency fund, even if it means contributing less to your retirement account along the way. Because you NEVER know what’s going to happen.

Who knew we would have to contend with a killer virus? No one.

That is why you throw gross amounts of money into your emergency fund before contributing to your retirement account. Do that, and the early withdrawal question should never even enter your mind.

Don’t Stop the Magic

Not convinced? There’s another reason tapping your retirement account early is a terrible plan: It spoils the magic of compound interest.

See, the growth in your retirement account hinges on the power of compound interest, or “interest on interest.” When you keep your paws off the account, instead of just earning interest on your initial investment, the interest you earn gets added back in… and you earn interest on that as well.

For example, say you invest $3,000 a month in a retirement account over the course of 20 years. Your investments return 6% on average, but you leave that money in your account, allowing it to compound. After 20 years, you’ve got $1.32 million, which is real money, folks.

But you won’t make that kind of progress if you periodically pull money out. Taking an early withdrawal for any reason—doesn’t matter if it’s debt, a medical emergency, or plague of locusts—interrupts the magic of compounding. And you wind up with a whole lot less down the road.

Jared Dillian
Jared Dillian