A 401(k) plan is a great way to set yourself up for retirement since you can contribute pre-tax dollars. In recent months, though, the government has made it easier to withdraw money from 401(k) accounts for those facing financial problems due to the COVID-19 pandemic.
It's good that the federal government has tried to offer flexibility to those looking for ways to cope with financial hardships, but taking money out of a 401(k) often isn't the best way to deal with a short-term need. Exercising this option means missing out on potential gains that can help build financial security in your later years.
Most Americans haven't taken advantage of early withdrawal opportunities. In fact, according to recent research by Fidelity Investments, just 3% of workers with 401(k)s on Fidelity's platform took a CARES Act distribution. Unfortunately, Fidelity also found the average withdrawal by those that did so was $12,100, a hefty sum. Those who took out that money won't just see their final 401(k) balance fall by that amount, though; they'll miss all the profits they'd have earned from it over the years.
How much difference does $12,100 make?
When you withdraw from your 401(k) plan and don't put the money back, you miss out on the chance for that money to earn compound interest. The consequence of this can be a significantly smaller retirement account balance. And just how much smaller depends on when you take the money out.
For example, say that you withdrew the average amount of $12,100 that Fidelity found in its research. Here's how much less you'd have in your retirement accounts by the time you reached the age of 66, assuming an 8% average annual return on your investment:
- $284,176 if you made the withdrawal at 25.
- $193,401 if you made the withdrawal at 30.
- $131,622 if you made the withdrawal at 35.
- $89,575 if you made the withdrawal at 40.
These are big numbers, but sadly far too many people don't realize a single distribution taken early could leave you hundreds of thousands of dollars poorer later in life.
How do you avoid missing out on 401(k) gains?
To make sure you don't find your nest egg substantially smaller, avoid taking early withdrawals from a retirement investment account if at all possible. The CARES Act allows you to take out up to $100,000 or 100% of your vested account balance (if it's smaller than $100,000) this year for coronavirus hardships without paying additional fees. Normally you would also be subject to a 10% tax penalty on early distributions.
You still have to pay taxes on distributions at your ordinary income tax rate, so some portion of your withdrawal would go to the IRS. Under the CARES Act, you can stretch out payment of the tax over three years, but normally it's due the year you take the distribution, leaving you with far less to spend. That means an early withdrawal costs you now and later, even without the penalty.
If you're facing hardship right now and feel forced to take a 401(k) withdrawal, the CARES Act also allows you to put back the money over the next three years without affecting future contributions (and without owing tax on your repaid distribution). Aim to do that, if possible, so you don't get off track with your retirement savings.
And for those lucky enough to be in a financial position to contribute to a 401(k) this year, try to invest as much as possible. Your investments now could multiply many times over by the time you reach retirement.