If at all possible, it’s best to avoid early withdrawals from your 401(k). Doing so risks delaying retirement, loss of potential investment growth, or significant reductions in funds available upon retirement. For many families, however, financial hardships leave very few options. If you find yourself facing the prospect of dipping into your 401(k), consider this detailed explanation of exactly what will happen and how best to mitigate the financial hit.
How Early Withdrawals Can Tax Your Retirement Savings
U.S. News — By Emily Brandon
If you can’t replace the money, an early 401(k) withdrawal will make you worse off in retirement.
Taking money out of your 401(k) before age 59½ typically results in taxes and penalties on the amount withdrawn. Investors who take early withdrawals also miss out on the tax-deferred growth their savings would have accumulated if they had left the money in the 401(k) plan or rolled it over to an individual retirement account. Here’s what happens when you take an early 401(k) withdrawal and how to limit the fallout.
Income tax. Regular income tax is due on each withdrawal from your traditional 401(k) plan. A worker in the 25 percent tax bracket who withdraws $10,000 from a 401(k) plan will owe $2,500 in federal income taxes on it, and perhaps more in state income taxes. When you receive a 401(k) distribution, 20 percent will typically be withheld for income tax purposes. So, when you withdraw $10,000 from a 401(k) account, you will actually only receive $8,000. You will need to come up with any additional tax you owe from the distribution itself or another source. “Many people who have cash-outs when they leave a job often are not leaving their job voluntarily, and some of this is being used as a temporary stopgap measure,” says Jack VanDerhei, research director of the Employee Benefit Research Institute. “If you have a situation where you don’t absolutely have to have the money, you should keep as much in the tax-advantaged accounts as possible.
You can avoid paying income tax on your 401(k) balance when you change jobs by leaving it in the 401(k) plan, rolling it over to an IRA or depositing the money in your new employer’s 401(k) plan. If you’ve already taken a cash distribution, you can still avoid paying tax on it if you put the entire amount, including the withheld 20 percent, into another tax-deferred account within 60 days. A 401(k) loan can also give you access to your retirement stash without paying income tax on it, but you have to pay it back with interest, and if you leave the job, the loan typically becomes due. If you can’t pay it back, the loan balance can become an early taxable distribution. “In virtually every case I can think of, I’d rather go with the loan,” VanDerhei says. “You have flexibility, you have the ability to put the money back in the account on a tax-advantaged basis and you can most likely avoid being taxed on it.”
Early withdrawal penalty. If you are under age 59½ when you take a 401(k) distribution, you must pay a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn. A 50-year-old in the 25 percent tax bracket who withdraws $10,000 from his 401(k) will forfeit over a third of the withdrawal, including $2,500 in federal income tax and $1,000 for the early withdrawal penalty. However, there are several exceptions to the early withdrawal penalty. If you lose or leave your job at age 55 or later (or age 50 for public safety employees), you can take distributions from the 401(k) associated with that job without penalty. You can also avoid the early withdrawal penalty if you are totally and permanently disabled, have medical expenses that exceed 10 percent (or 7.5 percent for those born before Jan. 2, 1949) of your adjusted gross income or are a member of the military reserve and take the distribution during a period of active duty that exceeds 179 days. Another strategy to avoid the penalty is to set up a series of substantially equal periodic payments at least annually over your life expectancy using a distribution method approved by the Internal Revenue Service.
Lost investment growth. An even bigger cost to early 401(k) distributions is the investment gains you would have gotten if you simply left the money in the account to grow. If you have $10,000 in a 401(k) account at age 30 and leave it there without any additional contributions, it will grow to $106,766 by age 65, assuming 7 percent annual returns. If you instead withdraw that money at age 30 and are in the 25 percent tax bracket, you will only get $6,500 after paying income tax and the early withdrawal penalty. “If you’re young, time will do some heavy lifting for you,” says Therese Govern, a certified financial planner for Therese Govern Financial Advisors in Seattle. “You want to keep it in that tax-deferred wrapper until retirement.” Outside of a retirement account, your savings will compound more slowly because you may need to pay taxes on the gains each year.
Less money in retirement. Many workers dip into their 401(k) plans early as a result of job loss or another financial setback. “When families experience financial shortfalls, their 401(k) accounts are often the only financial safety net they have,” says Marianne Cooper, a Stanford University research associate and author of “Cut Adrift: Families in Insecure Times.” “In hard times, families rely on these accounts so they can keep paying the bills.” But while an early 401(k) withdrawal may solve the immediate problem, it can create other financial complications later on.
Early 401(k) withdrawals can necessitate delaying retirement or lowering your retirement standard of living if you don’t take steps to get your retirement finances back on track. “While a necessary stopgap measure, withdrawing money from their retirement accounts puts families at risk in the future,” Cooper says. “Since few families can pay back what they withdrew, many will have a significantly smaller nest egg to live on later in life. A lot of people will never have enough to be able to retire.”