Why You Should Resist Taking a 401(k) Withdrawal

We all have unexpected financial needs from time to time: urgent home repairs, medical bills, the loss of a job, and the income that comes with it. When the financial squeeze is on, it’s easy to wonder if you should make a 401(k) withdrawal. After all, it’s money you saved, and your 401(k) plan offers you to take a loan against your savings for a reason, right? Well, yes. But you should think long and hard before exercising that option. Taking a 401(k) withdrawal may relieve your money problems in the immediate term, but cause more issues for you later on. 

There are two main reasons you should resist taking a 401(k) withdrawal: the taxes and fees you will pay in the near term, and the loss of the ability for the withdrawn funds to continue to grow and provide for you in retirement. 

Is a 401(k) Early Withdrawal the Same as Taking a Loan from a 401(k)? 

A 401(k) withdrawal is not the same thing as a 401(k) loan, but both can end up costing you. Let’s talk about the difference. 

401(k) Early Withdrawal

An early withdrawal from a 401(k) is when you remove funds from the account before you reach 59 ½ years of age. The funds are typically subject to a 401(k) early withdrawal penalty (early distribution tax) of 10% of the amount withdrawn: if you take out $10,000, you must pay a penalty of $1,000. That money is gone forever. (Think about how hard you worked to earn that $1,000 that you’ll never see again.) 

There are some circumstances in which you will not face a penalty for withdrawing funds before age 59 ½.  These include disability or certain medical expenses, dividing the 401(k) in a divorce, or using the funds for a first-time home purchase (up to a certain limit). But in general, the larger the withdrawal you make, the more dollars flow out of your pocket, never to return. The penalty exists for a reason: to keep you from using your retirement nest egg for reasons other than retirement. If it weren’t significant, it wouldn’t discourage people.

Early withdrawals from a 401(k) plan are also considered ordinary income in the year in which you receive them. That means you pay income tax on early 401(k) withdrawals, and if the withdrawals are large enough, they may bump you into a larger tax bracket. In some cases, between taxes and 401(k) early withdrawal penalties, you could end up with only about 60% of the withdrawal amount in your hands.

Those are the immediate financial consequences of an early 401(k) withdrawal. There are consequences waiting for you down the road, too—perhaps severe ones. You know that the more money you have in your retirement account, the more it can grow. By making a 401(k) early withdrawal, you risk the loss of potential future gains. Depending on how the market performs, a relatively minor withdrawal today could cost you thousands of dollars, or perhaps much more, in future earnings. 

When you consider how costly an early 401(k) withdrawal can be, it’s understandable that some people take advantage of the opportunity to take a loan from their 401(k). But a loan from a retirement account carries its own risks.

401(k) Loans

Many plans permit participants to borrow money from their retirement accounts. On its face, this sounds better than simply making an early 401(k) withdrawal. Typically, the maximum amount of the loan is $50,000, or 50% of your vested account value (whichever is less). 

As with most loans, a 401(k) loan must be repaid within a certain span of time. This is usually five years, but it may be longer if you are using the money to buy a primary residence. Also as with most loans, you must pay interest. The interest goes back into your 401(k). But if you fail to repay the loan according to its terms, it will be considered a withdrawal, and you could end up paying the taxes and penalties you thought you had avoided. 

It’s also important to understand that when you take a 401(k) loan, that money has to come from somewhere. That “somewhere” is the sale of mutual fund shares in your account. If those shares rise in value, you don’t receive the return that you would have while they were in your account. So, just like with a 401(k) early withdrawal, you miss out on growth that could have helped fund your retirement. 

What’s more, some 401(k) plans do not allow you to keep contributing to your 401(k) until you have repaid the loan. That means you aren’t saving for retirement, and you are also missing out on any matching contributions your employer would have made. Remember that your contributions to a 401(k) plan reduce your taxable income, so being unable to contribute means you may be paying more in income tax. As if all of that weren’t enough, taking money out of your 401(k), whether by early withdrawal or loan, removes protection from creditors that the assets had while they were in the 401(k). 

The Bottom Line on 401(k) Withdrawals and Loans

The ability to make an early 401(k) withdrawal or take a loan against your 401(k) exists for dire emergencies, and that’s about the only time you should use it. To learn more about 401(k) early withdrawals and potential alternatives, contact Estate Planning & Elder Law Services to schedule a consultation.