Compound Interest and my 401(k): What am I Really Missing out On?

September 17, 2020

The CARES Act made it easy to make 401K withdrawals without the hefty penalty and millions of Americans took advantage. It bridged the gap with unemployment rates soaring and the extra $600 benefit ending.

Millions of people found themselves between a rock and a hard place. They needed the money but also needed the retirement funds.

Are 401K withdrawals the right answer? They typically aren’t because no matter who you are or how much you withdraw, you lose the compound interest and there’s no way to make up for it.

Is it something to worry about?

 

How Much will you Lose? 

Let’s say you have $100,000 saved in your 401K and you need $10,000 to pay your bills on time during the pandemic. It might not seem like much, right? It’s only a tenth of what you saved and it’s your money, right?

True, but, look at what you’ll lose.

Taking out the $10,000 today cost you $17,909 over 10 years. So $7,909 in compounded interest. If you have 20 years until retirement, you lose $32,071 in interest just to take out that $10,000 today.

 

Selling Investments at the Wrong Time

When you withdraw from your 401K, you don’t withdraw from a cash account, typically. Most of your money is invested, which means your sponsor must sell assets to give you the cash. If you sell the investments at a non-opportune time, you may lose even more than the $10,000 you’re withdrawing.

 

How can you avoid it?

Don’t withdraw and find alternatives. If you absolutely must withdraw, talk to your financial advisor about the best investments to cash in that will have the least negative effects on your account.

Remember, even if you pay the funds back, you lost money initially when you sold the investments for less than you bought them for.

 

Taxes Complicate Matters 

Now you’ve lost compound interest and your investment in specific assets – but there are still taxes to consider.

You’ll have a tax liability on anything you withdraw. While you can spread the tax liability out over 3 years (until the end of 2020), it’s still money owed, taking away from the earnings you can invest.

If your 2020 income puts you in a lower tax bracket, it’s best to pay the taxes owed this year because you’ll owe less. But again, that takes away from the money you can contribute to your 401K which can earn compounded interest.

 

Should you Withdraw from your 401K? 

Try to avoid withdrawing from your 401K at all costs. In just 10 years, you could lose double of what you would have earned if you left it and triple in 20 years. If you have financial troubles, exhaust all other avenues, leaving your 401K for last. Compounded interest isn’t something you can make up for – the only way to earn it is time and leaving your investments untouched.

Rahul Iyer

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