There are various types of retirement accounts designed to incentivize and promote one to take charge of saving and investing for their future retirement.  These account types may include 401(k), 403(b), SIMPLE or SEP IRAs, and Traditional or ROTH IRAs.  Each account type has their own unique rules and characteristics; however, these retirement accounts offer the account owner tax advantages which may include a tax deduction upfront for contributions, tax deferral of earnings, or with some account types, tax-free withdrawals in retirement.  If following proper rules under these various retirement accounts, they can be massively advantageous.  However, if used improperly, they can be costly.  

The purpose of this article is to outline the true cost of early withdrawals from retirement accounts.  “Early withdrawal” is generally taking a withdrawal from the retirement account prior to the account owner reaching age 59½ years old¹.  Costs of early retirement account withdrawals include taxation, penalty, and opportunity cost. 

While everyone’s situation is unique, the following example will offer some insight into these costs of early withdrawal.  Bert, age 35, has a Traditional IRA account with $25,000 and has diligently been making contributions into the IRA since he first got his full-time job.  It’s summer in Wisconsin, so Bert decides to take a $10,000 withdrawal from his retirement account to put a downpayment on a camper.  Typical mid-age, mid-income, Midwesterner, Bert is in the 12% federal tax bracket and 5% state tax bracket.  Because Bert is not of retirement age and does not qualify for a penalty exception, he will also be penalized 10% federally and 3.3% at the Wisconsin state level.  To get the $10,000 camper down payment, Bert must withdraw $14,347 from the IRA ($14,347 – 12% federal tax – 5% state tax – 10% federal penalty – 3.3% state penalty = $10,000). 

Bert’s camper downpayment cost him an extra $4,347!  However, this amount is peanuts in comparison to the rarely recognized additional cost of early retirement account withdrawals – one of opportunity.  Say Bert’s IRA had underlying investments that earned him 7% per year long-term and he was to start using the retirement account balance when he turned age 65.  The $14,347 early withdrawal, if left in the IRA, would accumulate to $109,213 when Bert turns 65!  The true cost of Bert’s $10,000 camper downpayment really cost him over $100,000 considering all costs. 

To reduce early retirement account distributions, several strategies will help mitigate this costly mistake.  First, budgeting should be used to take proactive and deliberate decisions in what to do with your money.  If it is a priority for Bert to buy a camper, he should proactively plan and budget for this purchase.  Second, maintain a proper emergency fund.  In an instant, financial lives can be disrupted.  While every situation is fact dependent, the standard for personal finance is to have three to six months of living expenses set aside specifically in a fund only to be used for emergencies.  Having a properly funded emergency fund will reduce the temptation to take an early withdrawal from a retirement account when there is significant financial disruption.  Lastly, maintaining proper insurance for those catastrophic financial events will reduce the temptation of raiding a retirement account early. 

1 – This age can be different depending on account type and personal situation.