In most cases, if you're under 59 1/2 years old, you'll pay a 10% early withdrawal penalty on 401(k) distributions. This is in addition to federal and state income taxes you'll pay, all of which will be automatically withheld. However, the real cost of an early 401(k) withdrawal is the long-term effect on your nest egg.
Income tax withholding
The first thing you have to worry about is income taxes that will be withheld from your 401(k) withdrawal. Unless you're withdrawing after-tax (Roth) 401(k) contributions, the plan provider will be required to withhold 20% for federal income taxes, and may also need to withhold additional money for state income taxes, depending on where you live.
Two things to keep in mind. First, your actual tax liability for the withdrawal could be more or less than the 20% withheld. In fact, if you withdraw a substantial amount of money from your 401(k), it could potentially bump you into a higher tax bracket. So, there's a chance you'll still have to pay additional taxes out-of-pocket on the withdrawal.
Second, consider the effect this will have on the amount of your withdrawal. In other words, even if you live in a state with no state income tax, you'll need to withdraw significantly more money than you actually want to take out. For example, if you need $10,000 to cover some expenses, you'd need to withdraw $12,500 from your account to compensate for the tax withholding.
You may have to pay a penalty
In addition to paying income taxes on your early 401(k) withdrawal, you may also have to pay an additional 10% tax, known as an early withdrawal tax, or early withdrawal penalty.
There are a few exceptions to the penalty. However, it's important to be aware that some of the IRA early withdrawal exceptions do not apply to 401(k)s and other employer-sponsored retirement plans, notably the first-time homebuyer and college expenses exceptions.
Unless your 401(k) early withdrawal falls under one of the following categories, you should expect to pay an additional 10% tax:
- If the withdrawal's purpose is to correct an excess contribution.
- If you're deceased or totally and permanently disabled at the time of the withdrawal.
- If you're ordered to pay some of your 401(k) to another person (as part of a divorce settlement, for example).
- If you're over 55 and no longer working for the employer who sponsors the plan.
- If the withdrawal is to satisfy an IRS levy.
- If you're using the withdrawal to pay unreimbursed medical expenses in excess of 10% of your adjusted gross income.
- If you're a military reservist called to active duty (conditions apply).
- If you agree to take a series of substantially equal payments for at least five years, or until you turn 59 ½, whichever is longer.
- If the withdrawn funds are redeposited into an eligible retirement plan within 60 days.
The real problem with taking an early withdrawal
It's certainly not fun to pay taxes and penalties on an early IRA distribution, but that's not even the worst part of taking an early withdrawal. Rather, the big problem is the long-term effect of withdrawing the money.
Consider this simplified example. Let's say that you're 40 years old and have $80,000 in your 401(k). Based on a historically conservative 7% average rate of return, you can expect this to grow to about $434,200 by the time you're 65.
However, let's say that you need money to cover unexpected expenses, so you withdraw $25,000 from your account. Thanks to the 20% mandatory tax withholding, in order to get $25,000 out of your account, you'll really need to have $31,250 withdrawn. Also, keep in mind that this is before any state or local income taxes you'll have to pay, and doesn't account for the 10% penalty if you don't qualify for an exception.
What's more, your remaining balance can only be expected to grow to $264,600 -- nearly $170,000 less than if you left your account alone. This could make a big difference in your quality of life in retirement.
Of course, this is a simplified example, and doesn't take your future 401(k) contributions into account. Here's a calculator that can help you evaluate your personal situation, so you can gauge the true impact of an early 401(k) withdrawal.
The bottom line is that an early withdrawal from your 401(k) can have a serious and immediate impact on your tax bill, and could potentially cost you hundreds of thousands over the long run. So, be sure you consider your options carefully before you decide to take an early distribution from your retirement savings.
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