By Nirav Desai
Do you have a 401(k) through your employer? Lucky you! 401(k)s are an incredible resource to help you save for retirement. And if you’re really lucky, your employer may even throw in some money in the form of matching contributions to make your savings grow even more.
After hearing all about how you should take advantage of your 401(k), you enroll in the program and begin diligently saving for your future. But then life throws a curveball and you need money to cover an unexpected medical emergency or fund a major house repair. It might be tempting to dip into your 401(k) to take care of these needs, but it’s not the wisest move. Here’s why you should avoid early 401(k) withdrawals and what you can do instead.
The Immediate Consequences
It may be comforting to think you have a hefty savings account for the unexpected, but digging into your 401(k) for anything but retirement is definitely too good to be true, even though about 1 in 3 investors have done it. (1) This one seemingly simple financial decision can take a huge toll on your future retirement.
Withdrawal Penalties
To motivate us to keep our money set aside for our retirement years, the IRS penalizes withdrawals prior to age 59½ by slapping a 10% penalty on the amount you withdraw. You may have heard about some exceptions to this penalty, such as in the case of a disability or using the money to pay for certain medical expenses. But before you head to your HR department to start the process, remember that it’s not just the 10% penalty you need to worry about, it’s taxes too.
Tax Penalties
A major perk of contributing to a 401(k) is that you save on taxes now and only pay tax when you withdraw the money in retirement. But if you withdraw the money early, not only will you get taxed on your income earned from working, but you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket. This adds up more than you might realize. Between these two immediate consequences, most people get to keep less than 70 cents out of every dollar they withdraw early.
The Long-Term Consequences
Then there are the long-term consequences of cashing out before age 59½. When you save for retirement, you reap the benefits of compound interest, which helps the money you put away grow faster due to interest building upon itself. It means that not only do you earn interest on your principal, but on the interest you’ve already earned as well, so you are earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. This is the critical point most people lose sight of when they only look at their short-term financial situation.
Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. When you withdraw money that was growing, you put yourself behind on reaching your goals and with less time to build your accounts back up again.
An Early Withdrawal Case Study
Cashing out a 401(k) may seem harmless, but once you look at the numbers, you can see how much it’ll hurt your pocketbook in the future. Let’s look at a hypothetical example. Bob is 40 years old, runs into some financial trouble, and decides to cash out the $50,000 he has saved over the past 20 years.
Bob understands he’ll have to pay some penalties and taxes, but he doesn’t take the time to actually run the numbers. He makes the withdrawal, checks his bank statement, and is shocked at what he sees.
After paying 24% in federal income taxes, 6.5% in state income taxes, and a 10% early withdrawal penalty, Bob’s $50,000 has dwindled to $29,750—just over half of his original 401(k) savings.
On top of that, Bob just erased all his momentum from 20 years of tax-deferred growth. He was at the point where his account was starting to snowball. He was earning interest off his interest. Now Bob has to start again from scratch; and at age 40, he has a lot less time to rebuild that snowball effect.
An Alternative Option
If you ever find yourself in a tough spot financially and are considering cashing out your 401(k), it’s more than worth it to speak to a financial advisor before making any rash decisions. It may turn out that you have other, less financially devastating options available to you, such as taking out a loan on your 401(k), taking a hardship withdrawal, or even applying for a short-term loan or a HELOC from your local bank.
Whether you have questions about cashing out your 401(k) or you’re interested in creating a personalized financial plan to help reach your goals, the Qubera Wealth Management team is happy to help. Schedule a free consultation online today or reach out to us at 323.999.1095 or mail@quberawealth.com to see if we are the right fit for you.
About Nirav
Nirav Desai is founder and financial advisor at Qubera Wealth Management, a fee-only Registered Investment Advisor, providing comprehensive financial solutions for their clients. Nirav is passionate about acting as a fiduciary for his clients so they never have to wonder if their future is in good hands. He holds a master’s degree in computer science from USC and an MBA in finance and real estate from the UCLA Anderson School of Management. Nirav is dedicated to helping his clients realize their life’s passions, achieve balance in their lives, and attain true financial freedom. Other than his career, Nirav loves science fiction, action movies, and traveling with his family. Learn more about Nirav by connecting with him on LinkedIn.
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(1) https://www.fidelity.com/viewpoints/retirement/cashing-out