A 401(k) account is designed to help people save and invest money for retirement. In exchange for letting you contribute pre-tax money to your account, the IRS expects you to leave the money in the account until close to your retirement years. Unfortunately, some people may find themselves in a situation where they need access to money they may not have in a checking or savings account.
Although it may be an option, here are three reasons why you shouldn't withdraw early from your 401(k).
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1. There may be early withdrawal penalties
Since you contribute pre-tax money to a traditional 401(k), you'll owe income taxes on any withdrawn money. However, if you make an early withdrawal from your 401(k) -- which is before the age of 59 ½ -- you'll likely be subjected to an additional 10% early distribution tax.
Depending on your current tax bracket, the income tax plus early distribution tax could represent a large portion of your withdrawal amount. For example, if you make $90,000 annually as a single tax filer -- which would put you in the 24% tax bracket for tax year 2022 -- and withdraw $50,000, you'd only receive $33,000.
- $50,000 * 10% early distribution tax = $5,000
- $50,000 * 24% income tax = $12,000
- $5,000 + $12,000 = $17,000 in taxes and penalties
Although not common, there are a few exceptions that may exempt you from the 10% early distribution tax, including:
- Permanent and total disability
- Employment severance
- Unreimbursed medical expenses
- Plan provider is terminates
2. Loss of potential growth on withdrawn funds
Compound interest happens when your money (and the interest it earns) grows exponentially over time -- making it one of the greatest phenomenons when it comes to saving for retirement. When you take an early withdrawal from your 401(k), you're not only potentially losing a large chunk of it to taxes and penalties; you lose the growth potential on the withdrawn funds.
Let's say you want to withdraw $50,000 from your 401(k). You're not only losing around $17,000 to taxes and penalties, you're losing the chance for that $50,000 to make you more money. If you received an 8% annual return on that $50,000, it would be worth close to $108,000 in 10 years. If you left it alone for 20 years, it'd be worth over $233,000.
When you withdraw early from your 401(k), don't just think about the immediate impact; consider the loss of the potential gains from the withdrawn money.
3. You may be better off taking a loan from your 401(k) plan
Some plan providers allow you to borrow from your 401(k). Usually, you can borrow up to 50% of your vested amount up to $50,000. Unless you're taking this loan to buy a primary residence, you must pay the money back within five years. You also have to pay the money back with interest, but the interest paid goes into your account, so you're essentially paying it to yourself.
If you find yourself in a situation where you may need a lump sum of money, instead of taking an early withdrawal from your 401(k), consider taking a loan from it to save yourself money on income taxes and the early distribution tax.
Consider all of your options
Taking early withdrawals from your 401(k) is expensive. If you find yourself in a financial situation where you need access to a large amount of funds, you should consider all of your options before opting for an early withdrawal from your 401(k). Of course, life happens, and you may find that doing so is your only option, but by carefully considering all aspects of the decision, you can ensure you're making the right choice for you.
