Early IRA Withdrawal Creates Big Risks

You probably won’t be surprised to hear that early IRA withdrawal is a major trend in retirement investing.

A new study from the Employee Benefits Research Institute put a number on it this week: Among the lower-earning half of savers ages 61 to 70, nearly half (48%) were taking out money ahead of time.

Even among the top half of earners the early IRA withdrawal number was surprisingly high, at 42.7% for the third quartile and nearly 29% of the highest quartile group.

The amount of money varied. The lowest income group withdrew 17.4% of the savings, while the highest took out 11.5%.

Under IRS rules, all IRA savers have to start making required minimum distributions at age 70 and 1/2. That some start early is a symptom of having saved too little, leaving work too early, some combination of these factors or, potentially, a well-considered strategy.

Given how far off the mark Americans are on total savings for retirement, however, the latter seems unlikely.

Similarly, a large percentage of people take Social Security at age 62, historically as high as nearly 50%, (although the number has fallen in recent years), even though waiting until 66 or as late as 70 means getting a higher monthly benefit.

It’s easy to say that near-retirees should hold off on tapping retirement income sources. After all, they face the same financial pressures as everyone else — gas prices, rent or mortgage, the cost of food — and often get asked unexpectedly to cover the costs of their grown children.

Nevertheless, early IRA withdrawal risk is hard to understate. The reason why is the “time value” of money.

This can be a difficult concept to master, but if you have ever taken out a car loan you probably already get it: The longer the loan, the more you pay. The interest rate might be fixed at a seemingly low number, but if you stretch it out over more years the dollar number you pay gets bigger.

Let’s use the car example: If you buy a $20,000 car at 3% interest rate and finance it over 5 years, your total interest paid adds up to $1,562.

If you did the same loan over three years instead: $938. Yes, your payments each month would be higher, but the cost of your loan falls by nearly 40%.

If you had a chance to buy anything else at such a steep discount, you’d jump at it. Yet people fall for the same trick over and over, choosing the lower payment on longer terms as if  the lower monthly hit to the wallet means lower total cost.

It can make some sense if you manage to invest the difference in a way that earns you more in the meantime, but that rarely happens in real life. Mostly, we just pay too much to borrow and fail to realize the damage to our finances.

Unseen early IRA withdrawal risk

Back to retirement. If you take an early IRA withdrawal — or early Social Security for that matter — does it hurt you financially? You bet it does!

In the case of Social Security, the risk is lower. Since the government runs the retirement program as a pension fund, you are somewhat protected from “longevity risk,” that is, running out of money in your old age. You’re not protected from political risk, of course, and inflation risk is a concern, but those are different topics.

If you fail to do the “time value” calculation on your IRA, though, chances are high that your early IRA withdrawals will cost you big. See, the longer you take out money (time), the less you can take out safely (value). It’s a car loan in reverse.

Unlike Social Security, you can very easily spend down your IRA to zero and have no way to recover, should you live longer than you expect. Other than owning an annuity or other form of guaranteed income, you are on your own when it comes to figuring your real risk of outlasting your savings.

That’s why, in some cases, investing for growth in a retirement portfolio can be an important consideration, and why “pension manager thinking” is the key to retiring well on the assets you have.