The True Cost of an Early 401(k) Withdrawal
Tapping into your 401(k) isn’t as easy as cracking into a piggy bank. It’s also more expensive. After early withdrawal penalties (and losing out on future earnings) what's left of your 401(k) balance is far less than expected.
Borrowing or withdrawing from your 401(k) early can result in hefty tax penalties and significant compound interest losses.
While exceptions exist, the most common withdrawals for education or buying a home are still subject to tax penalties.
If you’re borrowing against a 401(k), loaned funds won’t grow in value and will be considered a withdrawal if you leave your employer while you’re paying off the loan.
Your 401(k) account may be the most tempting financial reserve to tap into during a cash crunch.
But to avoid temptation, consider the true costs of taking an early 401(k) distribution.
If you’re thinking of taking an early distribution from your 401(k) account, you’re not alone. According to a Bloomberg report, “Since the housing collapse of 2008…taking money from a 401(k)—and worrying about the consequences later—became a more attractive alternative and a record number of Americans made early withdrawals in 2010 following the financial crisis.”
So before you proceed, consider all the fees and tax penalties which exist in the first place to discourage such actions.
Here, we provide an overview of what penalties and tax consequences to expect.
Note that the tax rates and the example figures mentioned throughout this article are based on the tax rates at the time this article was published. Tax rates are subject to change from year to year, so please defer to IRS guidelines for current rates.
401(k) Penalties for Early Distribution
In 2011, Americans withdrew about $57 billion prematurely from their retirement funds. As a result, the Internal Revenue Service (IRS) collected a staggering $5.7 billion from 401(k) early withdrawal penalties.
When you withdraw from your 401(k), you’re giving up way more than extra pocket money; you’re also losing out on the amount of future compounded returns on the 401(k) balance that you’ve so diligently accrued.
We’ve crunched the numbers and the results are surprising. You may think twice about cashing out, not rolling over into an Individual Retirement Account (IRA) when switching employers, or borrowing against your 401(k) funds.
Retirement plan participants pay into most plans on a pre-tax basis and get the benefit of deferring taxes until they are 59½ years of age, when personal income tax rates are likely to be lower than during peak working years.
Likewise, to discourage the liquidation of retirement accounts and to help workers boost savings rates, the IRS imposes a penalty and enforces income taxes on all retirement plan distributions before age 59½. If you’re considering an early withdrawal from your 401(k), the amount you end up with after penalties are assessed will be significantly less than the amount withdrawn.
To get a better idea of the potential tax penalty associated with an early 401(k) withdrawal, consider a hypothetical example in Robert, a 30-year-old worker who plans to take an early distribution.
Let’s assume that Robert cashes out $14,000 from his 401(k), just under the average amount of $14,300 cashed out by 401(k) participants ages 20 to 49. He’s also a single tax filer, earns $50,000 per year (which puts him in the 25% tax bracket), and lives in Illinois, which has a flat 3.75% state tax rate.
Here’s what Robert’s $14,000 early distribution looks like after all taxes and penalty fees are assessed:
Robert will keep only $8,575, or a little more than half (61%) of his original $14,000 distribution. The $5,425 he won’t have access to doesn’t even account for what he’ll lose by not keeping his money invested over time, which can be substantially more.
Compound Interest Losses
If you’re considering taking money from your 401(k) account, you should be aware of how much that money can accrue over time. Understanding the amount you may be missing out on may convince you to let your 401(k) account alone.
“We know people say that it’s about investing for the long term, and that the earlier you start saving, the more powerful it is, but we don’t realize just how powerful,” said Dan Egan, Betterment’s Director of Behavioral Finance and Investments. “Every day, dollars are making more dollars if you save and invest them. It’s at a rate that can become mind-boggling, particularly if you just don’t look at the account.”
Let’s take another look at Robert’s scenario to see just how much those dollars can compound.
If Robert keeps his retirement account intact (instead of taking a $14,000 distribution at age 30), he’ll reach the average retirement age of 62 with $152,147 saved, assuming an average 8% annual return and pre-tax growth, as shown on the chart below. Had Robert kept contributing to his account, which he didn’t do in our example, his account could have grown even more over the same time period.
Source: Betterment. Assumes an initial deposit of $14,000 and an annual growth rate of 8%.
A look at the chart above shows that it’s not just 30-year-old Robert who can benefit from compounding. Time can be an investor’s best friend. The results are powerful to see, for investors at any age. In short, the more time one has until funds are withdrawn, the greater the potential gain.
In the end, an average $14,000 401(k) distribution yields a worker like Robert just $8,575 in usable assets but results in a potential loss of more than ten times that amount over time.
Exceptions to the Rules
If you leave your employer after the year you turn 55, you may not be subject to the penalty.
Other limited situations exist where the penalty could be waived, such as permanent disability or medical expenses exceeding 7.5% of adjusted gross income, or a court order to pay money to an ex-spouse or dependent.
Hardship withdrawals, unfortunately, are subject to the 10% penalty, and include unreimbursed medical expenses for you or your dependents, a principal residence purchase, payment of college tuition for dependents or children who are no longer dependents for the next 12 months, payments necessary to prevent eviction or foreclosure from your home, funeral expenses, and certain repairs or damage to your principal residence.
Many employers offer the opportunity to borrow against 401(k) accounts. These loans are not subject to taxes or penalties, and you may contribute to the plan while you pay back the loan.
One downside, however, is that if you leave your employer before the loan is repaid, you must pay back the remaining balance. If not, it may be considered a withdrawal and subject to the tax penalty.
These loans do not appear on credit reports, and often have low interest rates, but because you’re paying back principal and interest to yourself, these payments will actually add to your 401(k)’s value.
One minor tax consideration is that your interest payments are made with after-tax dollars, and they’ll be taxed again when you withdraw the funds in retirement.
401(k) loans generally allow borrowing up to 50% of your account balance. However, keep in mind that borrowed funds won’t be participating in the market or earning dividends as they otherwise would in the 401(k).
Lastly, before you take out a loan against your 401(k), make sure you can afford to make the loan payments from your paycheck.
Is a 401(k) Distribution Really Worth It?
Because everyone’s situation is unique, this is a question you can only answer for yourself. As we’ve seen, there’s not only a short-term penalty in the form of taxes and fees but also a significant long-term drag on expected returns and retirement funds.
As with any big financial decision, forethought and planning goes a long way to making sure you achieve your goals despite life’s inevitable setbacks, and you may wish to consult a financial advisor for more thorough planning.
More from Betterment:
- How to Roll Over a 401(k)
- Can You Have a 401(k) and an IRA?
- This Calculator Helps You Decide Whether to Invest in a 401(k), IRA, or Both
Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. This article is intended as educational only and is not investment or tax advice.
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