When money is tight, your emergency fund is the first place you should look for help. If you don’t have a robust emergency fund in place, taking some money from your 401(k) early may seem like an attractive option. But should you make early 401(k) withdrawals?
A lot of people are stressed about their finances in 2020, and no wonder. The pandemic has made it tough for everyone. Perhaps you’ve lost your job, faced decreased hours, been ill, or been forced to leave work to manage remote schooling for your children. Financial hardship is abundant, and many of us are looking for a way to bridge the gap between paychecks.
In general, taking early 401(k) withdrawals isn’t the ideal solution to a cash flow problem. But let’s look closer at why that is.
What Is a 401(k)?
First of all, here’s a quick refresher of what a 401(k) is and how it works.
401(k)s are employer-sponsored retirement accounts that enable workers to stash away significant income. Similar to the 401(k) are the Roth 401(k), Solo 401(k), 403(b), and 457(b). You need to work for an employer who offers this type of retirement account to take advantage of one.
With traditional 401(k)s, you contribute money from your paycheck tax-free, plus your contributions grow tax-free. Therefore, you benefit from a reduction in your taxable income in the present. You do, however, have to be prepared to pay taxes when you eventually begin taking withdrawals from your 401(k) account.
The Roth 401(k) works similarly to a traditional 401(k). The primary difference is that if you use a Roth, you make contributions from after-tax dollars, then withdraw funds tax-free in the future.
Solo 401(k) investment accounts are also available to those who are self-employed.
Typical 401(k) Restrictions to Consider
While a 401(k) is a great investment vehicle for you if your employer offers it, there are important restrictions to keep in mind. Even though the money belongs to you, 401(k) funds aren’t available to you at any time you want.
You need to know when you’re allowed to start withdrawing money from a 401(k) account. It’s intended for retirement, which is partly why you don’t have access to it until age 59.5.
What Happens When You Make Early 401(k) Withdrawals?
Let’s say you’ve got financial obligations you just can’t meet, and you’re younger than 59 and a half. You have a decision to make. First of all, check with your employer to find out whether they even allow you to make early 401(k) withdrawals.
Often, you can take some of the money out of a 401(k) before that age, but you’ll pay a hefty price:
- 10% early withdrawal penalty if you take money out before you reach age 59.5 years
- That’s 10% in addition to the regular tax rate you’d pay on withdrawal income
- Don’t forget the cost of lost years of growth for your investments and a lower 401(k) balance upon your retirement
The 10% early withdrawal penalty alone can leave you in a sticky situation. If you should become unemployed, you might consider an early 401(k) withdrawal. You might not have enough in your emergency fund to cover the bills for an extended unemployment, so taking some distributions a few years early may be a solution.
If you haven’t faced this in 2020, there’s a good chance you know someone who has. Making early 401(k) withdrawals should not be done without a lot of careful consideration.
Example of Early 401(k) Withdrawal
Let’s say you’ve run into some financial hardship due to loss of income or large emergency expenses. Your emergency savings won’t cover everything, so withdrawing $20,000 from your 401(k) now can help you make it through.
- $20,000 early 401(k) withdrawal
- 24% Federal income tax bracket
- 5% state income tax
- 15 years away from retirement
- 6% anticipated rate of return
Input those figures into a simple 401(k) withdrawal calculator to learn just how much you’d lose in penalties, plus the cost of potential gains during lost investment years.
By removing that $20K from your retirement account 15 years early, you’d forfeit a lot of money both now and later.
First, you’d pay the 10% penalty, which in this case is $2,000.
Then, factor in federal taxes of $4,000, an additional $1,600 in federal withholding, and $1,000 in state income tax. That’s a total penalty of $8,600! Your tax situation might not be quite the same, but there’s still a lot of money to be lost.
All told, you’d walk away today with just $11,400 out of the original $20,000 you were withdrawing.
I don’t know about you, but seeing my funds drop nearly in half is enough to make me pause and try to find another way to make ends meet.
This early-withdrawal calculator even provides the handy metric of how much money you could be missing out on. If you’d left the 20 grand sitting in the 401(k), its potential value would be $47,931 in 15 years when you’d intended to retire.
Now, you’re looking at not only a loss of $8,600 in taxes and penalties, but also a loss of the chance to more than double your original $20K by retirement age. In this example, you’ve given up a total of $36,531—and all to gain just $11,400 today. Just imagine how much you’d forfeit in gains and fees if you took out even more!
So the moral of the story is: making early 401(k) withdrawals is an option, but it’s a pretty terrible option. You stand to lose a heck of a lot of your hard-earned money when you decide age 59.5 is just too far off.
Current Caveat: The CARES Act
As you likely know, the CARES Act was signed in spring of 2020 to provide economic relief to millions of American families. One aspect of this legislation was to waive the 10% early withdrawal penalty for those needing funds before age 59.5.
The bill allowed for 401(k) investors to take a “hardship distribution.” This could be up to $100,000 from a 401(k) or other similar retirement account. This provision will last until December 31, 2020.
During the worst of the coronavirus pandemic, the CARES Act has (hopefully) enabled folks to get access to their money early. Maybe they had lost income and didn’t carry much liquid money in an emergency fund.
Of course, if you took advantage of this opportunity to make early withdrawals without the extra 10% penalty, you’d still face the lost investment income over time. This means early 401(k) withdrawals remain best kept as a last resort.
Safer Alternatives to Early 401(k) Withdrawals
It may be that you’re really struggling to handle all of the monthly bills at this point. Maybe you’re starting to lose hope and you just need some cash in your hand to make it through the day.
First of all, you should consider all of the resources at your disposal. Be sure to take a look at your emergency fund balance to see whether that money could pay the bills for a while. This is what your emergency fund is for, after all.
You might also search for ideas to help you cut expenses, at least temporarily. If you’re stretched thin, but you manage to find something in the budget to get rid of, great!
For some people, your 401(k) company may permit you to take out a loan from your 401(k) balance, rather than a withdrawal. This can provide the same effect as withdrawing as far as your finances today. The great thing is that it allows you to pay back the money borrowed over time, minimizing the amount lost.
Generally, a 401(k) loan is a much better option than a payday loan or other types of loans. This is a very reasonable strategy when you simply need money right now. You can’t put off all of your expenses because of a global pandemic or a medical or family emergency.
Using a 401(k) loan can help you get back on your feet. Commit to repaying the loan promptly when things improve. This can help you to breathe a little more easily when anxiety and hardship are high.
Don’t Make Early 401(k) Withdrawals Unless Necessary
The basic guideline or rule of thumb with these types of retirement accounts is to follow the expectations whenever possible. That means doing everything in your power not to take money out of a 401(k) until you’re at least 59 and a half. This is similar to an annuity plan.
You lose quite a bit of your investment by taking funds out before the appropriate time. As with most financial situations, patience yields the greatest benefits.
That being said, of course at times you may face circumstances beyond your control. Maybe you need to finance medical treatment for a loved one. Let’s face it: you’re less concerned about your future retirement when comparing it to the life of someone you love. So if you’ve exhausted all other options, an early 401(k) withdrawal may be the answer.
Just remember that you’ve set aside that money for a reason: your retirement years. All of the advice against taking early 401(k) withdrawals is not meant to make anyone feel bad for considering it. No—it’s meant to help you to consider what’s truly best for you and your future.