401(k) Withdrawals May Sound Like Easy Money, but Consider This Instead

You want to do everything in your power to save your retirement accounts just for that: retirement. Unfortunately, that’s not always possible, and some unforeseen circumstances can put you in a desperate financial situation. If you find yourself in this situation, know that you’re not the first person it’s happened to, and you definitely won’t be the last.

Taking an early withdrawal from your 401(k) may seem like the easy way to go during these times, but make sure you’re aware of the implications and exhaust other options first.

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It’s costly to make an early withdrawal

If you withdraw from your 401(k) before you reach age 59 1/2, you’ll be subjected to a 10% early withdrawal penalty. Since you contribute pre-tax money into your 401(k), an early withdrawal will also spark a tax bill. The IRS does this to avoid a situation where people contribute pre-tax money into a 401(k), lower their taxable income, and then withdraw the money essentially tax-free.

Depending on your tax bracket, an early withdrawal from your 401(K) could cost you a sizable amount of the money you initially planned to withdraw. If you’re in the 24% tax bracket and withdraw $20,000 early, you would have to pay a $2,000 early withdrawal fee, as well as $4,800 in income taxes. By the time you received your withdrawal, it would be around two-thirds of the amount, which could present another issue.

In this scenario, if a situation comes up and you need to withdraw $20,000 early from your 401(k), you would have to withdraw around $30,000 just to ensure you receive the full $20,000 you need: $30,000-$3,000 (early withdrawal penalty)-$7,200 (income taxes) = $19,800.

There are some exceptions to the 10% early withdrawal rule, including:

Withdrawals made after you become disabled
Death of the primary accountholder, as heirs are typically not subject to the early withdrawal rules
Unreimbursed medical bills over a certain amount
IRS tax levy
Active duty military

It’s not just about the present

The reality is that retirement isn’t cheap, and there’s no such thing as being too prepared. Part of being prepared for retirement costs is understanding that strictly saving enough for retirement is nearly impossible; you need your money to grow. That’s why money in retirement accounts, like a 401(k) and IRAs, is intended to be invested and not just sitting around like money in a regular savings account.

Yes, early 401(k) withdrawals can be expensive, but what often goes overlooked is how much future value the withdrawn money could’ve generated. For example, $20,000 is a lot of money today, but when you consider that at 8% average annual returns, it could be worth over $93,000 in 20 years, an early withdrawal becomes a bit more “expensive.”

Consider a loan instead

Before taking an expensive early withdrawal from your 401(k), you should consider taking a loan from your account instead. You can either borrow 50% of your vested balance or $50,000, whichever is less. For instance, if your vested balance is $80,000, the most you could borrow would be $40,000; if your vested balance is $200,000, the most you could borrow would be $50,000.

Although you’re borrowing the money from yourself, you must also pay yourself back the 401(k) loan with interest, which also goes into your account. Usually, your plan provider will automatically take the payments from your paycheck — after tax, unlike your contributions — and you’ll have five years to pay it off. If you don’t pay off your loan, any unpaid balance will be considered a taxable distribution, and you’ll face the 10% early withdrawal fee and income taxes if you’re under 59 1/2.

When used correctly, 401(k) loans can save you thousands compared to an early withdrawal.

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