Dave Ramsey Warns Us Never To Use A 401k To Make This Payment

Investing in a 401(k) can be a great idea. This retirement account tends to be linked to your workplace, although independent contractors can set up their own 401(k) account and benefit from the tax breaks baked into this approach to retirement planning. Capitalize reported that, at the end of 2023, almost 60% of American workers had access to 401(k) options through their employer. Beyond the ability to invest money before it's taxed, many companies offer contribution matches, giving their employees free extra money to invest for their future. It's also entirely possible to borrow from your 401(k) or even simply take an early distribution. These actions can help mitigate extreme financial hardships in the present, but they should never be taken lightly. Dave Ramsey, known for his 7 Baby Steps money management plan, is a major proponent of maximizing your investments. He's also targeted a specific 401(k) withdrawal purpose that investors should never consider.

A caller on Ramsey's show asked about withdrawing from her 401(k) to purchase a home in 2016. She noted that her rent was being hiked up and it was no longer affordable. Instead of searching for another potentially tenuous rental option, she had considered tapping into her retirement savings to buy a home for her family. Her intentions were certainly noble, but Ramsey suggested that this was actually a much bigger point of vulnerability than she realized.

The immediate financial hit feels like a ton of bricks. If you're taking an early withdrawal, you'll pay income taxes on the money alongside a 10% penalty on top. Your taxes are built on progressive brackets. That means each dollar earned over the next limit is taxed in its entirety at the new threshold until it reaches another cap. A worker who makes an early withdrawal will have that distribution piled on top of their regular earnings, so it could be taxed at a much higher level. In his caller's case, Ramsey suggested that she should anticipate losing around 50% of an early distribution's value to tax implications and penalties.

Another option is a 401(k) loan. This allows you to take money from your account without penalty rates or the tax sting. But you only have five years to pay back the amount borrowed, plus interest, or it is reclassified as an early distribution. If you're utilizing a large chunk of the account to pay for a significant purchase like real estate, you may be setting yourself up for twofold failure. You will have to deal with the more immediate strain of repaying the loan, along with a potential tax hit later if you can't make the window.

No matter how you frame taking money out of your 401(k), there's another loss that takes place when you withdraw rather than deposit cash there. With an early distribution, you short circuit the account's long term growth potential. Making consistent deposits and allowing investments the time they need to grow exponentially are key to preparing for major retirement expenses. By taking money out of your account, you're slowing — and maybe even stopping — that growth. You will need to double down on your deposit schedule to try to make up for lost time, but with annual caps on your contributions, this may not be possible even with an aggressive investment approach.

A 401(k) loan offers a different menace to manage on some plans. Until you pay back the loan, you might not be able to make any deposits into the account. Taking a loan may sacrifice your ability to save with this tool for years, as a result. These are setbacks that can permanently derail your retirement savings goals. The lost growth isn't something you'll feel immediately, but to make up for the lack of compounding interest on those dollars, you might end up needing to work additional salaried years or scale down financially.