Yahoo Finance 5 Unknown Consequences of Withdrawing Early From Your 401(k)
Dipping into your 401(k) before retiring might feel like an easy way to get fast cash — but it’s typically not a wise move. While you may be aware that you’ll pay income taxes plus a 10% penalty on any vested funds withdrawn from tax-advantaged 401(k) accounts before age 59 1/2, there are several other potentially devastating consequences that could affect your dreams of an easy, fun, and financially sound retirement.
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The impacts of an early 401(k) withdrawal can be severe enough that financial advisors strongly recommend it only as an absolute last resort. Here are five big downsides you need to know about taking money out of your 401(k) early, according to experts.
The 10% Early Withdrawal Penalty
“The IRS charges a 10% penalty tax for early 401(k) withdrawals. That’s on top of the taxes you pay for making any 401(k) withdrawal,” said Todd Stearn of The Money Manual. “Depending on how much you’re withdrawing, this can be a pretty big hit for your retirement savings.”
There are some exceptions where the 10% penalty doesn’t apply — for example, some medical expenses, avoiding foreclosure, or taking withdrawals after leaving your job at age 55 or older. But in most cases, expect to pay the 10% penalty plus regular income tax on any pretax 401(k) contributions and investment earnings you withdraw early.
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Higher Taxes Due to Your Income
“Your 401(k) withdrawal is taxed. This is true whether you withdraw early or not,” Stearn said. “But if you make a withdrawal while you’re working and your salary puts you in a higher tax bracket than you would be in after retirement, you’ll pay more taxes on that early withdrawal.”
The mandatory 20% federal tax withholding (plus any state taxes) is simply an upfront payment toward whatever your actual income tax liability is for the year. If you’re in a higher tax bracket while working, more taxes could be due when filing your return.
Loss of Decades of Tax-Deferred Growth
“The number one consequence that people don’t think about when withdrawing early from their 401(k) is not the taxes and penalties, it’s the future growth potential they are taking away from themselves,” said Jake Skelhorn, CFP and former Merrill Lynch advisor now at Spark Wealth Advisors.
For example, “If you’re 30 years old and you cash out your $50,000 401(k), you’re really taking away $380,000+ from your 60 year old self (assuming a hypothetical 7% rate of return for 30 years). That could mean the difference in working another 5-10 years instead of retiring!” Skelhorn emphasized.
Due to compound growth, even a relatively small 401(k) balance withdrawn decades before retirement can significantly reduce your nest egg’s future value.
Withholding May Not Cover Your Full Tax Bill
“The other thing people don’t realize is that the mandatory 20% tax withholding is just an estimate,” Skelhorn said. “Depending on your total income that year, you could owe much more than 20% on the withdrawal. If you’re in the 24% tax bracket, you’d owe a total of 34% on the withdrawal after factoring in the 10% penalty.”
The 20% federal withholding could leave you with a hefty additional tax bill due if you’re in a higher marginal tax bracket. Speaking to a tax professional can help determine exactly how much you’ll need to withhold or pay in quarterly estimates.
Opportunity Cost of Lost Earnings
Every dollar you withdraw early is no longer invested and compounding its tax-deferred growth for retirement. So even after paying taxes, penalties and withholding, you’re still missing out on years’ worth of future earnings that withdrawn money could have generated if left untouched.
This makes it even harder to rebuild your retirement savings after an early 401(k) withdrawal. By leaving funds alone until absolutely necessary, you avoid permanently reducing your nest egg’s future value.
Key Takeaway: Consider Alternatives Before Tapping Retirement Funds
To avoid these negative consequences, Stearn recommends exploring other options first.
“Are you a homeowner? Look into getting a home equity loan or HELOC, which can be under 8% right now if you have equity in your home. Or if you need to pay off high-interest debt, get a 0% balance transfer credit card for up to 24 months. Setting up a budget and cutting expenses can also help ‘find’ extra money,” he pointed out.
Brandon Robinson, president and founder of JBR Associates, shared that you should also make sure your emergency fund is adequate.
“By putting a small percentage of your after-tax earnings aside into a savings account or money market account, you will avoid having to dip into your retirement savings because of a large expense, lost job or any other life event,” he said. “Make sure you build this fund with 6-12 months of your living expenses. Even if your returns on the emergency fund is 1-2%, that’s fine. Your earnings gained by keeping the money at work in the 401(k) will more than offset that.”
Taking an early 401(k) withdrawal should be an absolute last resort after exhausting all other possibilities. Your future retirement lifestyle could depend on leaving those compounding savings untouched for as long as possible.
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This article originally appeared on GOBankingRates.com: 5 Unknown Consequences of Withdrawing Early From Your 401(k)
