No matter which financial planner you consult, one piece of retirement advice that you will always hear is to consistently contribute as much as you can to an employer-sponsored retirement plan such as a 401(k). However, when hard times hit, it can be difficult to know that all those funds, which are technically yours, are tied up and inaccessible. It’s tempting to want to find a way to cash in on your 401(k) in order to reap immediate relief from financial woes.
If this happens to you, know that you aren’t alone in finding it hard to keep those 401(k) retirement funds off limits. However, whether your financial need is a home down payment, a financial emergency, or an unexpected medical bill, it’s very important to carefully consider the pros and cons of early 401(k) withdrawals before taking any money out. Any and all unplanned withdrawals prior to retirement age can mean sacrificing years of potential 401(k) retirement plan growth down the road, as well as facing increased income tax and financial penalties in the immediate future.
The Rules and Penalties
The biggest reason 401(k) plans are such excellent tools for saving for retirement is their tax benefits. First, each contribution made to the account is tax-deductible on your tax return for the year you contribute. Second, the growth of your money in the 401(k) plan is tax-deferred, meaning you don’t pay money on growth until it is withdrawn. But, these benefits only work in your favor when you stick to the rules governing 401(k) plans. Withdrawing money early results in penalties that can wipe out the tax benefit you’re receiving and stifle future growth.
Nearly all 401(k) plan withdrawals are taxable as ordinary income, with the notable exception of Roth plans. Ideally, funds are not withdrawn until after retirement, then (and only then) taxes are paid in a manner similar to paying taxes on other types of income, such as a paycheck. With smart retirement planning, most people will be in a lower income bracket when they are retired. This means they will owe less taxes on withdrawals from a 401(k) plan during retirement than they would have paid when they initially earned it.
With most 401(k) plans, withdrawals are not anticipated until the employee turns at least 59 ½ years old. However, it’s possible to make early withdrawals and incur an early distribution penalty tax of 10% of the amount of the withdrawal. Keep in mind that an early withdrawal has multiple disadvantages. Not only is the amount of the withdrawal considered taxable ordinary income by the IRS; not only is the withdrawer likely in a higher tax bracket than they will be after retirement; not only will that money not be kept there to grow and multiply, but now the employee has to pay a straightforward penalty as well!
Exceptions for Early Withdrawal
There are some exceptions to the early withdrawal penalty. These exceptions are intended to help people who face a limited set of financially difficult circumstances. Keep in mind that withdrawals under any of these situations will still result in taxable ordinary income, although they won’t result in the 10% early withdrawal penalty. Individual plans may also have their own requirements.
- Qualifying disability
- Termination of employment when at least 55 years old
- Allowable medical expenses
- Withdrawals related to a qualified domestic relations order
- Withdrawal accompanied by sufficient arrangements to make repayment
Some plans will have hardship exceptions that allow contributors to apply for a penalty-free withdrawal not of a type listed above. All kinds of financial hardships might fall under this umbrella term, and a plan may or may not get very specific. For some plans, the only way to know for sure whether you are eligible for a hardship withdrawal without a penalty is to apply with your plan administrator and find out.
Considerations Before Making an Early Withdrawal
Before you decide to make an early withdrawal from your 401(k) plan, see if you have other options available that are less costly in the long-term. Many people have access to credit cards, short-term personal loans, and even home equity loans, all of which are often a better choice than taking money out of retirement accounts. Once the savings are withdrawn, they often cannot be replaced because of annual limits on contributions.
According to a Fidelity study, the average cash-out from a 401(k) for a person under age 40, who takes an early withdrawal because of job change, was over $14,000. This sort of withdrawal can set retirement plans back considerably, and is difficult or impossible to replace. This doesn’t just mean less money in the retirement account right now, it means even more missing at retirement, since that $14,000 will not have a chance to grow in interest and value in the decades left until retirement.
For example, a contribution over the course of just one year of $5,500, which grows at an average annual return of 7 percent, with tax-deferred status, can turn into as much as $58,000 after thirty-five years. With this example, it’s easy to see why early withdrawals can have hugely negative long-term consequences on retirement goals.
One more consideration, which is often an option, is to check with your plan administrator about a 401(k) plan loan. Taking out a loan against your 401(k) avoids the taxes and penalties that come with an early withdrawal. However, you would need to pay the account back, and the amount you borrow will come from liquidated investments, which means if the financial market shows gains during that time, the amount you borrow isn’t available to realize those gains.
What’s more, many employers will insist that an outstanding 401(k) loan be repaid immediately if you are terminated or leave your job. If you fail to repay the amount, the remaining balance will be considered in default and become an early withdrawal after all, which is then subject to income taxes and the early withdrawal penalty.