Withdrawing Money From Your Traditional 401(k) | Finances | MD&D #39

Evidence based insights into physician compensation, RVUs, contracts, healthcare economics, and personal finances. For residents, fellows, and early-career attendings.

Life and Finances, in Medicine.

This week I met a student who was planning to withdraw $10,000 from her 401K account to pay for a car loan. Those were the only $10,000 she had in her retirement account. And she did not understand the consequences of what she was about to do (that is if the rules of her retirement plan allowed her to withdraw that money). She could not fathom the importance of money compounding in her 401K. Because she didn't know how compounding works. No one explained to her how retirement money works. No one told her that with careful planning, she could invest and retire way before age 65, if she so wished. That's another example emphasizing that there's a lot of work to do in educating our students, residents and fellows on financial issues.

In the United States, we tend to confuse our credit capacity with wealth. The fact that you can pay for something doesn’t mean that you can afford it. And we tend to live under the premise of installments, that never end. And then when you look at your account and you see all these bills that you need to pay, and at the same time you look at your 401K and it seems like money sitting there doing nothing, in theory. So, you feel tempted to withdraw from that account and pay your debt.

I have been there. I am the head of a big department now, but at some point, I was just like many of the young people I regularly teach. Man, I sound so old now!

Let’s get back to the 401K situation here. It is hard not to look for instant gratification. As human beings we’d rather have the instant pleasure of paying something off than the delayed reward of building wealth in the long run. I am not advocating to avoid paying your debts, not at all. In many cases that is the best financial decision you can take, knocking off all your credit card debts, for example. But paying debt is just as important as building wealth. Not just because you will have enough money to retire at age 65. But because investing in general, may allow you to retire way before that age. If you plan and act accordingly. This is due to one of the most beautiful words in financial lingo, in my opinion: compounding. The capacity of your money to multiply multiple times its value if you invest it and let it be.

But for this to work, you need two factors, consistency and repetition. And as doctors we know a lot about these two. I wish someone had explained this to me when I was a resident. But at least I can help the next generation.

Think about going to the gym. If you go for a short period, you feel the pain of exercising, and you decide to stop, just to return a couple of months later to start from scratch, you won't see results. Another example: studying to become a doctor. If you study for a few months a year, instead of doing it consistently for your four years of medical school, your results will reflect that lack of consistency. A similar thing happens with your 401K. You won’t see results unless you are consistent. Even if it is with a minimal amount of money. But you must put it in your retirement account regularly and forget that it exists. And then compounding kicks in.

In the gym, once you start building muscle it's easier to build more muscle on top. The same way when you are in medical school, once you learn the first concept, the second concept attached to it becomes easier to understand. The same thing with investing. Once you start putting money in your account, that money multiplies much, much faster by compounding. Even if the market goes down one year, historically the market tends to recover over time. And if you invest wisely and leave the money alone, in the long run you could be wealthy before you know it. If that is what you want, of course.

Now, what if you have a credit card charging you 30% interest rate, you cannot pay it off in a reasonable time frame, and you need to withdraw from your 401K. Let’s do the math. You withdraw $5,000 to pay off debt. If your income tax rate is 22%, for example, you owe $1,100 in federal income taxes plus a $500 early withdrawal tax. That is $1,600 lost, 32%, before considering state taxes, fees and without counting on the money you will never earn because you withdrew what you had invested. It is very important that you allocate money for both, to pay your credit card and to invest separately. And for this, planning is a must. Withdrawing 401K money may be one of the most expensive financial decisions you make in your life. Now, if you have a true emergency and have no other choice, then do as you must.

I honestly wish I had known this when I was just starting. But it comforts me that I can help the next generation avoid my mistakes, or lack of action in this case.  

Paying your debt and investing are not mutually exclusive. But planning is a must for success in both.

"Our favorite holding period is forever."

 Warren Buffett

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