How not to pay for your goal
There may be more convenient methods to pay for your purchase, but they usually have consequences.
Using credit cards
If you're looking to reach your goal in the most expensive way possible, then using plastic to pay for it is the way to go. Credit card balances are essentially pricey loans that can charge interest rates as high as 20% or more.
Putting a $5,000 vacation on a credit card could lock you into payments for the next 17 years. In the end, that $5,000 vacation could actually cost you more than $12,000.*
Carrying a credit card balance will also result in a hit to your credit score, which could hinder your ability to meet other financial goals.
Tapping into retirement money
Taking out money you had earmarked for retirement (or another goal, like college) could hurt you in a number of ways.
If you withdraw money from a tax-deferred account—a traditional IRA, a 401(k), or a 529 account, for example—you'll be hit with a 10% penalty in most cases. And don't forget to set aside part of what you withdraw, because you may need to pay income taxes on it as well.
So, for example, if you need to withdraw $10,000, you could be looking at total taxes and penalties of $3,500 (if you're in the 25% tax bracket)—leaving you with only $6,500 to use right now.
Withdrawing from a 401(k) means you'll lose a lot
And that might not even be the worst part.
The money you withdraw could eventually threaten your ability to reach your other goal. Going back to our example, $10,000 might seem like a small drop in your retirement bucket, but because your money will also miss out on compounding, you could be looking at a final loss of more than $57,000.
The true cost of taking a retirement withdrawal
This hypothetical example assumes that you miss out on 30 years of compounding at an annual 6% return. It doesn't represent any particular investment nor does it account for inflation.
Figure you'll just take some of your 401(k) money as a loan instead? Remember that if you fail to pay back the loan—or if you leave your employer and can't repay the loan immediately—you'll face the same taxes and penalties that come with a withdrawal.
Using your emergency fund
As the name suggests, your emergency fund is meant for large, unplanned expenses. Obviously, if you spend it on something else, you won't have any cushion when you encounter an actual emergency.
Don't have an emergency fund yet? Start one today.
So how should you save for your goal?
Investing your savings in a separate account is the best way to reach your goal.
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Saving for a goal: The basics
You won't pay any income taxes on the amount your account earns until you take the money out. (Note that with Roth accounts, assuming you meet all requirements, the earnings become tax-free at that time.)
A type of account created by the IRS that offers tax benefits when you use it to save for retirement.
When earnings on invested money generate their own earnings. For example, if you invested $5,000 and earned 6% a year, in the first year you'd earn $300 ($5,000 x 0.06), in the second year you'd earn $318 ($5,300 x 0.06), in the third year you'd earn $337.08 ($5,618 x 0.06), and so on. Over longer periods of time, compounding becomes very powerful. In this example, you'd earn over $1,600 in the 30th year.
This bar chart shows how a $10,000 investment can potentially increase to 5 times its size over the course of 30 years. When you keep your money invested (versus withdrawing it), it has a greater opportunity to grow.
Over 3 years, your money could grow to $11,910. Over 6 years, your money could grow to $14,185. Over 9 years, your money could grow to $16,895. Over 12 years, your money could grow to $20,122. Over 15 years, your money could grow to $23,966. Over 18 years, your money could grow to $28,543. Over 21 years, your money could grow to $33,996. Over 24 years, your money could grow to $40,489. Over 27 years, your money could grow to $48,223. And over 30 years, your money could grow to $57,435.