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The biggest retirement savings mistake and how to avoid it

The Motley Fool logo The Motley Fool 10/6/2017 Wendy Connick

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If you're still several decades from retiring, then building a steady source of retirement income may not seem like your top priority. However, messing up your retirement savings plan early on in your career can make it almost impossible for you to recover the lost ground later.

One of most tragic mistakes a worker can make is dipping into their retirement fund early. Unfortunately, it's becoming quite common: A study by PricewaterhouseCoopers found that about one-third of Millennials and Gen X workers have already taken money out of their retirement savings accounts, and around one-half believe they'll take an early distribution in the future.

Taking an early withdrawal comes with a host of consequences, none of them good. The most significant consequence is a long-term one: Once you retire, not only will you be missing the money that you took from your accounts, but you'll be missing all the money that the money would've earned for you.

Let's say you take $5,000 out of your 401(k) to pay for a major car repair. Assuming your investments generate an average 7% return per year, 30 years from now that $5,000 would've been worth $38,061. Was that car repair really worth thirty-eight grand?

The immediate consequence

You won't have to wait until retirement to suffer some of the drawbacks of an early withdrawal, either. Taking money out of your traditional 401(k) or IRA before you reach age 59-1/2 means you'll pay both income taxes and a 10% early withdrawal penalty on the amount distributed.

Consider the previous example. If you're single and in the 25% tax bracket, then that $5,000 early withdrawal will cost you an extra $1,250 in taxes plus the $500 penalty, for a total tax bill of $1,750. And you'll have to pay those taxes on your tax return for the current year -- not after you retire. Can you afford to pay a tax bill of that magnitude?

Alternatives to an early withdrawal

Given the consequences of taking an early withdrawal from your retirement savings accounts, it's a good idea to develop one or two alternatives. That way, when the car dies or some other crisis occurs, you have a less painful way to deal with the problem.

The best alternative is to have an emergency savings account with enough money in it to cover a minimum of three months' worth of basic expenses. If you can't manage that much, start with what you can and set up a small automatic transfer to keep the account growing. Even saving just $50 per month will add $600 per year to your emergency savings fund.

If a crisis hits that you can't pay for with emergency savings, the next best option is to turn to a credit card. This can result in huge interest payments, especially if you take a long time to pay off the balance, so only use a card if you truly can't delay the purchase. Try to find a balance transfer offer to use -- this will minimize your interest charges, especially if you can pay it back promptly. Many credit card lenders will be happy to extend such an offer to you if you have decent credit. If you have little or no emergency savings, keep at least one credit card with plenty of available credit on it to fund emergencies instead. Think of this credit card as your less-than-ideal emergency savings account, and don't ever use it for ordinary purchases. If you have to stick it in the freezer to resist the urge to use it, by all means do so.

In some cases, borrowing from your 401(k) is an option -- but it's usually best saved as a last-ditch approach. A 401(k) loan allows you to pay the interest to yourself instead of to a credit card company, which is a plus. However, the money you've borrowed is no longer earning returns in your account, which can set back your retirement savings substantially. And if you can't pay back the loan by the deadline, or if you change employers before it's paid, you'll be required to pay back the entire balance at once or face steep penalties. Think long and hard before turning to your retirement savings for emergency funding.

Finally, if neither of these options is available to you, consider waiting until you can afford to pay for the emergency. In the case of the car repair, would it be possible to take public transportation for a few months until you can afford the repair? Could you just get part of the repair done now and wait on the rest until later? Is there a friend or family member who could give you rides or perhaps even lend you a car for a few months? Delaying an emergency purchase isn't always possible, but if it is, it could save you a lot of money in the long run.

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