When you need money quickly and you don't have the cash at hand, you may start looking for the cheapest and easiest way to get the funds you need. A 401(k) withdrawal might seem to fit that bill: It's your money, so there's no need to fill out any loan paperwork, and no risk you'll be turned down because of poor credit.
The costs of an early 401(k) withdrawal aren't always obvious at first, but you'll feel them both at tax time and in retirement. Fortunately, it might not be your only option when you find yourself in a tight spot.
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What's considered an early 401(k) withdrawal?
Generally, a 401(k) withdrawal is considered "early" if it happens while you're under age 59 1/2. You typically face a 10% early withdrawal penalty for doing this, but there are exceptions:
- Giving birth or adopting a child (up to $5,000 per child)
- Becoming permanently and totally disabled
- Sustaining an economic loss as a result of a federally declared disaster (up to $22,000)
- Being a victim of domestic abuse (up to the lesser of $10,000, or 50% of the vested account balance)
- Using the money for emergency personal expenses (up to the lesser of $1,000 or the vested account balance over $1,000 -- limit once per calendar year)
- Taking substantially equal periodic payments (SEPPs)
- Paying for unreimbursed medical expenses in excess of 7.5% of your adjusted gross income (AGI)
- Being a qualified military reservist called to active duty (certain distributions only)
- Quitting your job in the year you turn 55, or 50 if you're a public safety worker (withdrawals only allowed from your most recent employer's plan)
- Developing a terminal illness
If any of these things apply to you, you won't have to pay the 10% early withdrawal penalty, though you'll still owe income taxes on your distribution. This is because you get a tax break on traditional 401(k) contributions in the year you make them.
If the funds come from a Roth 401(k), that could save you a bit on taxes, but there's a good chance you'll still owe something. You pay taxes on the portion of your Roth 401(k) withdrawal that's attributable to earnings.
For example, if you have a $10,000 Roth 401(k) balance, $1,000 of which comes from earnings (10% of the total balance), and you make a $2,000 withdrawal, you'd owe taxes on 10% (the amount of earnings making up the total balance), or $200. The remainder would be tax-free because it's considered your personal contributions that you already paid taxes on.
The long-term consequences of early 401(k) withdrawals
In addition to the tax bill, early 401(k) withdrawals hurt your savings' growth. If you take $2,000 out of your 401(k), you're not just costing yourself that lost money, plus whatever you pay in tax penalties. You're also giving up the earnings you could've had if you'd left that $2,000 invested in your account.
Over 20 years, that could've turned into nearly $13,500 if you earned a 10% average annual return. For larger 401(k) withdrawals, the consequences are even more drastic. You'll have to save even more money per month going forward to reach your retirement goal. That's why it's best to avoid early 401(k) withdrawals if you can.
Instead, consider these options:
- Saving up over time: This could be an option if you don't need the money immediately.
- Working out a payment plan: Some creditors are happy to allow you to pay in installments, which may be easier to work into your budget.
- Taking out a loan: You can use a personal loan for any reason, and you don't have to put up any collateral.
- Taking out a 401(k) loan: This is where you borrow against your 401(k) balance, and it may help you avoid the 10% early withdrawal penalty because you pay back what you owe over time.
You might still decide that an early 401(k) withdrawal is your best move. In that case, you may want to consult with an accountant to see what kind of effect this could have on your tax bill so you can plan accordingly.
