Breaking into retirement funds: It's not sacred money, but beware of long- and short-term impact on your finances
Jan. 6—TUPELO — Having a retirement plan should provide income after you leave the workforce, helping to pay for the bills that continue to flow.
But an increasing number of retirement savers are withdrawing from their accounts while also increasing their debt. With higher costs and inflation, Americans are finding difficulty in making ends meet, and they're having to dip into their savings.
According to Fidelity Investments' third-quarter 2023 retirement analysis, account balances have decreased slightly since the previous quarter, while withdrawals and loans are inching up, showing the impact economic events such as inflation and market volatility can have on their finances.
"Americans have become accustomed to riding the economic waves of the past several years, and (the) quarter (was) no different," said Kevin Barry, president of Workplace Investing at Fidelity Investments. "They are learning how to stay afloat in very challenging financial conditions — including having enough money set aside should an emergency arise."
But an early withdrawal from retirement funds also incurs a double-whammy: the IRS taxes the money, and early withdrawal fees take another chunk.
Money taken out of a 401(k) before age 59 1/2 is hit with a 10% early withdrawal penalty, as is a 20% tax withholding penalty. Also, funds withdrawn from a 401(k) are taxed as income. For example, a 40-year-old who withdraws $10,000, would get 20 initially withheld. If the individual is in the 24% tax bracket, there would be an additional amount due at tax time. So, the individual receives only $6,600 and owes $3,400 in taxes and penalties. The exact amount owed can vary depending on your tax bracket, circumstances and location.
However, Scott Reed, a Certified Investment Management Analyst and Accredited Investment Fiduciary Analyst and CEO of Hardy Reed in Tupelo, said individuals shouldn't have to feel guilty about taking money out when needed.
"Money is there to use," he said. "There are too many people in our business who (say) you need to keep your money until you die. The fact is, money is there to use for good purposes. So, our job isn't to talk them out of things, but to help them make decisions. Sometimes, the best decision is to take money out — but you have to understand what you're giving up."
About 2.6% of savers, or roughly 138,000 people, took a loan from their workplace plan in the third quarter this year, borrowing an average $10,778, according to Empower, an account administrator, which analyzed its internal data on 5.3 million accounts. That share increased from 2.3% in Q3 2022 and 1.7% in 2020.
SAVINGS RATES 'REMAIN STEADY'
According to Fidelity's analysis of more than 45 million IRA, 401(k), and 403(b) retirement accounts, retirement balances were up over a year ago, and "young investors are making great strides with the long-term, and savings rates remain steady and strong this quarter."
Average retirement account balances decreased slightly from the previous quarter, but 401(k) balances are up. The average IRA balance was $109,600 in the third quarter, a decrease of 4% from last quarter, but it's an 8% increase from a year ago and a 28% increase from 10 years ago. The average 401(k) balance decreased to $107,700, down 4% from the previous quarter, but an 11% increase from a year ago and a 27% increase from 10 years ago. For 403(b)s, the average account balance decreased to $97,200, down 5% from last quarter, but up 11% from last year, and a 46% increase from 10 years ago.
Total 401(k) and 403(b) savings rates remain steady, Fidelity said. The total savings rate for the third quarter, reflecting a combination of employee and employer 401(k) contributions, was 13.9%, consistent with Q2 and up slightly from a year ago. The savings rate remains just below Fidelity's suggested savings rate of 15% (including both employee and employer contributions). Boomers in the workforce continue to save at the highest levels (16.7%).
Gen Z investors continue to make huge strides with retirement savings, with a 63% increase in IRA accounts year-over-year and overall dollar contributions increasing 51%. The third quarter also saw a 69% increase for females in this age bracket. Across generations, Roth IRAs continue to be the preferred retail retirement savings vehicle, with 61.2% of all IRA contributions going to Roth.
"It's impressive to see Gen Z entering the workforce and prioritizing retirement savings," said Rita Assaf, head of Fidelity's Retirement Products. "While market conditions are constantly changing, the benefit of making consistent contributions over the long-run is clear — a more secure retirement."
THE EXPENSIVE LESSON
What Reed is referring when he said individuals need to realize what they're giving up when withdrawing retirement funds early is the potential income lost from compounding interest.
For example, over 10 years, a $100,000 deposit receiving 5% simple annual interest would earn $50,000 in total interest. But if the same deposit had a monthly compound interest rate of 5%, interest would add up to about $64,700.
Once a withdrawal is made, compounding interest is lost.
And Reed knows how painful that can be. When he started his current career 40 years ago after leaving the family business for Hilliard Lyons, he withdrew his $5,000 retirement plan account and used it to pay for his Jeep CJ-7.
"I paid off that note because it was costing me a lot each month," he said. "I got over to Hilliard and had all this financial planning software and wanted to see what that move cost me, because I was more enlightened at that point and would not have done that."
As it turns out, that decision cost Reed roughly $250,000 — what would have been in his retirement account had he left it alone until age 60.
"The miracle of compound return is incredible," he said.
HARDSHIP WITHDRAWALS
There are legitimate reasons to tap into retirement, and such "hardship withdrawals" that do not apply the 10% fee due to "an immediate and heavy financial need" under IRS regulations:
—Medical care expenses
—Costs related to buying a home
—Educational expenses
—Costs to avoid eviction
—Funeral expenses
—Certain expenses to repair damage to your primary home
Reed said withdrawing retirement funds, whether it's from a Roth IRA, 401(k) or 401(b) is ultimately left to the investor and the needs they're trying to fulfill.
"You give up any of that compound return to take out that money, but that doesn't mean it's not the right thing to do," he said. "So, is it good to take out money from retirement plan to buy a bigger flatscreen TV? I can't imagine that being a good idea."
But Reed said withdrawing from a retirement fund doesn't always require an emergency, either.
"Would I take money to make a down payment on house that I'll live in the rest of my life and avoid paying that 7% interest on that note? Maybe I do some of that, but not maybe all," he said. "There are right things to use it for. Is it OK if you're 40 and have to take money out for a big life event? Yes. But remember, you have to pay the 10% plus taxes on it."
It's not sacred money, he said. It's there to be used. He just recommends you use it wisely.
"You just have to look at all sides of it," Reed said. "Make your move, and be OK with it."
