Here's What Happens When You Withdraw Money From a Traditional 401(k) Before Retirement

It'll cost you hundreds or even thousands of dollars.

Many employers offer employees the option to invest in a traditional 401(k), a tax-advantaged retirement savings plan. Employees contribute with pre-tax dollars, meaning you're not taxed until you withdraw the money -- ideally, during retirement.

But folks don't always have the luxury of waiting until retirement to withdraw cash from their 401(k) plan. In 2021, I was smacked by margin calls and decided to remove thousands of dollars from my traditional 401(k) account.

The results were brutal: early withdrawal penalties and loss of tax-deferred growth. Here's what happens when you withdraw money from a traditional 401(k) before retirement.

Early withdrawal penalties

You're hit with significant penalties if you withdraw money from a traditional retirement account before age 59 ½. I had to pay hundreds of dollars to withdraw my funds. Here is what you'll have to pay when withdrawing money from a traditional 401(k) before retirement:

• Regular income tax (varies by tax bracket)
• 10% early withdrawal penalty

For example, I withdrew $5,000 from my 401(k) before I turned 59 ½, and I was in the 12% tax bracket, so I paid $600 in taxes and an additional $500 in early withdrawal penalties. Not great.

Loss of tax-deferred growth

When you withdraw early from a traditional 401(k), you miss out on the tax-deferred growth of your investments. The longer your money stays in the account, the more time it has to grow and compound, which boosts your retirement savings.

By withdrawing your money early, you're giving up that potential growth. You may have to retire later or save more aggressively to meet your retirement goals.

Alternatives to early withdrawal

Some plans allow you to take out a loan from your 401(k). While you will have to pay back the loan with interest, you won't incur taxes or penalties as long as you repay it on time and remain with your employer for the duration of the loan.

Reasons you might potentially take out a 401(k) loan include:

• To pay off a tax bill
• To pay for a house
• To pay off a higher-interest loan

Generally speaking, you don't want to withdraw early for any reason. Loans incur interest, and if you don't pay 401(k) loans back in time, you're slapped with an additional 10% early withdrawal penalty. Don't invest in a 401(k) with the intention of withdrawing funds early.

Other sources of funds: personal savings, emergency funds, or even low-interest credit cards or personal loans. While these options may not be ideal, they may be a better alternative to early withdrawal from a 401(k) if you're in a financial pinch.

Avoid early withdrawals

Withdrawing money from a traditional 401(k) before retirement has consequences: taxes, penalties, and loss of potential growth. While early withdrawal is sometimes necessary, it's essential to consider all your options and the long-term impact of your decision.

Consider putting money into an emergency fund to pay for unexpected financial hardships. If I'd had emergency savings, I wouldn't have withdrawn thousands of dollars from my 401(k) and paid the price. The best high-yield savings accounts offer generous interest on your cash and are a great place to keep your emergency fund.

Try an IRA account

Looking for a place to park retirement savings? You can set up an individual retirement account (IRA) without an employer, for any reason. You can roll over money from a 401(k) to an IRA without incurring financial penalties.

To transfer money from a 401(k) to an IRA, contact the financial company managing your 401(k). They'll let you know any requirements you need to meet before they transfer the money to an IRA. The best IRA accounts offer low fees and other perks.

Withdrawing money from a traditional 401(k) before retirement is expensive. You pay taxes and penalties, and lose out on potential growth. While sometimes it's necessary to withdraw early, consider alternatives like using money from an emergency fund before making the decision.