The Downside to Withdrawing From Your 401(k) Early
By Marjorie L. Rand, CPA, CFP®, RICP®
After the rocky few years we’ve all endured, more people than ever are looking forward to retirement. While the ideal retirement may vary from person to person, I think it’s safe to assume we all want it to be worry-free and rewarding. Another thing all retirees have in common is the need to have sufficient funds to support them throughout their retirement years. One of the most reliable ways to achieve this goal is with a fully funded retirement to invest in and grow your 401(k). If your employer contributes to or even matches the funds you put into your account, all the better to make it grow even faster!
But we are now all painfully aware that life is unpredictable. Sometimes unforeseen circumstances may put you into a financial bind and tempt you to dip into your nest egg early. Although this might seem like a good idea in the moment, doing so could hurt you in the long run. Are you thinking about cashing out your 401(k) early? I urge you to first consider the following consequences and take time to search for alternative options.
Early 401(k) Withdrawal Consequences
It may be comforting to think you have a hefty savings account for the unexpected, but digging into your retirement accounts for anything but retirement is definitely too good to be true, even though about 51% of investors have done it and 1 in 5 took a withdrawal during the pandemic. But just because others are doing it, remember that this one seemingly simple financial decision can take a huge toll on your future retirement.
To motivate us to keep our money set aside for our retirement years, the IRS penalizes 401(k) withdrawals prior to age 59½ by slapping a 10% penalty on the amount you withdraw. You may have heard about some exceptions to this penalty, such as in the case of a disability or using the money to pay for certain medical expenses. But before you head to your HR department to start the process, remember that it’s not just the 10% penalty you need to worry about, it’s taxes too.
A major perk of contributing to a traditional 401(k) is that you save on taxes now and only pay tax when you withdraw the money in retirement. But if you withdraw the money early, not only will you get taxed on your income earned from working, you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket. This adds up more than you might realize. Between these two immediate consequences, it’s possible you would only keep less than 70 cents out of every dollar you withdraw early.
Growth and Goals
Then there are the long-term consequences of cashing out before age 59½. When you save for retirement, you reap the benefits of compound interest, which helps the money you put away grow faster due to interest building upon itself. It means that not only do you earn interest on your principal, but on the interest you’ve already earned as well, so you are earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. This is a critical point that most people lose sight of when they only look at their short-term financial situation.
Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. When you withdraw money that was growing, you put yourself behind on reaching your goals and with less time to build your accounts back up again.
How an Early Withdrawal Could Hurt You
Cashing out a 401(k) may seem harmless, but once you look at the numbers, you can see how much it’ll hurt your pocketbook in the future.
Let’s say Michael (30 years old) withdraws $25,000 from his 401(k) to pay off student loans. Since he earns $70,000 a year, he is taxed 22%, but his withdrawal pushes him into a higher tax bracket for 2022 and he will be taxed 24% instead. On top of that, he lives in New Jersey and faces a 9.3% state tax. Here’s the math:
‒ 24% federal tax ($6,000)
‒ 10% early withdrawal penalty ($2,500)
‒ 6.37% New Jersey tax ($1,593)
= $14,907 total distribution!
That’s a substantial loss. Not only did Michael sacrifice more than $10,000 at the front end, but he also forfeited the compound interest on the $25,000, an amount that could take him years to invest again.
An Alternative Option
If you are considering cashing out your 401(k) to help you out of a tough financial situation, it’s wise to speak to a financial advisor before making any rash decisions. After some examination, it may be that you have other, less financially devastating options available to you—such as taking out a loan on your 401(k) or taking a hardship withdrawal.
At Rand Financial Planning, we are always here for our clients when questions or concerns like these arise. We provide guidance that keeps our clients’ whole financial picture in perspective so they can stay on track towards achieving their goals. If you’re interested in creating a personalized financial plan to reach your goals, I am happy to help. Schedule a 20-minute introductory call or reach out to me at 908-895-2406 or firstname.lastname@example.org to see if I’m the right fit to help you on your financial journey.