(LifeWire) - Despite the best-laid plans, things come up that can cause an investor to consider taking an early distribution of money from a retirement plan. Medical bills, weddings, houses -- some big expenses can arise.
Beware, though: unless your need is dire, pulling money out of a retirement plan before you reach 59 1/2 can be a disastrous financial move.
Taxes and Penalties of Early Distribution
For starters, there's the wrath of Uncle Sam.
When you withdraw money from most retirement accounts, including a 401(k) or an individual retirement account, you'll usually pay income taxes on it in the year you take it out. The only exception to that rule is a Roth IRA; its contributions already have been taxed. And even on a Roth, you can expect to pay taxes on any gains if you take money out before 59 1/2.
Then there's the 10% penalty that's levied on early withdrawals that don't fit a set of categories that the Internal Revenue Service has deemed penalty-free exceptions, such as certain types of medical costs, college tuition expenses, first home purchases and avoiding foreclosure.
Lost Wealth and Early Distribution
Then there are the potential gains you stand to lose.
The tax-deferred status of a retirement account is one of the most powerful tools for building wealth available to the common investor, but bailing out early cedes the advantage.
An example: $100,000 growing at 8% a year inside a tax-deferred retirement account would grow to more than $466,000 in 20 years. If you take the $100,000 out, deduct the $10,000 penalty and invest it in a taxable account, it would grow to a bit more than $288,000. That's a whopping $178,000 less -- even if only a 25% federal tax and no state tax is paid on its gains.
Take the money out, spend it on a new Ferrari and ... well, you're out $10,000 plus tax right away, and you've lost a potential $366,000 in gains over 20 years.
