401k Early Withdrawals: Are They Worth it?

May 14, 2020

This article is not meant to be a substitute for the advice of a financial planner or other investment professionals. It is just meant to give you some background information.

Did your employer offer you early retirement? Are you changing jobs? If so, you may wonder about your 401k. In the event of a job switch, you can rollover your 401k to your employer’s new plan, pay fees to keep it the same, roll over the account into an IRA, or accept a cash-out. In terms of early retirement, if you don’t have the needed financial resources to make up for the extra years of retirement, a 401k cash out is one of your few options, aside from getting another job.

A new job and early retirement are just a couple of instances in which an individual may ask for an early 401k withdrawal. At the time, it seems like a good idea. After all, who is going to turn money away? Not many. With that said, it is important to look at the big picture. When taking an early withdrawal from your 401k, it is not as simple as taking money from your bank account. You are hit with many rough patches and consequences. What are they?

Taxes and fees. 401k plans are designed for retirement. For that reason, you should wait until you are at least 59 ½ years old to collect your savings. Even in the event of early retirement, you are required to pay a fee. That is a 10% fee. Next, there is the tax factor. Your employee contributions throughout the years were tax-sheltered. You did not pay tax on that income. Yes, you have known all along that you will pay taxes on this money, but are you ready to pay them now? You must be if you intend to take an early withdrawal. Depending on the size of your 401k, this can be a lot of money. Add that in with your 10% early withdrawal fee and you may not have much left.

As previously stated, it depends on the situation. If just switching jobs and in your early 20s or 30s, consider the alternatives. These include paying management fees to keep your 401k plan with your former employer, rolling over to your new employer’s program, and rolling over to an IRA. For most, even the maintenance fees are less than the early withdrawal penalty. As for early retirement, what are your options? If you did not intend to retire for 10 more years, try to find another job or offer to take a pay cut. You are still provided with employment, can continue to contribute to your 401k, and earn livable income until you are prepared to retire. If you prepared to retire in 2 or 3 years, look at your savings. Is there enough to get you by until you get access to your 401k without the penalties?

Finally, it is important to look at the total this will cost you. If you are in your late 20s and switching jobs, you may have only acquired $10,000 or so in your 401k. You are young in life and would like to purchase a new car or a new home. You think this money could come in handy and it probably would, but how much of that money are you going to see? Continue reading on for an example, using the above mentioned $10,000.

As previously stated, there is a 10% early withdrawal fee. Right there is $1,000. Then, the income is taxable. You can use the internet or call the Internal Revenue Service (IRS). Find out what your tax rate is. On average, most Americans pay around 20%. You can expect this to be about $2,000. Not only do you need to pay federal taxes on this income, but state taxes too. Determine your state income tax. They vary greatly. Even if it is only 5%, that is $500.

By using the above-mentioned formula, you are left with $6,950. You paid $3,500 in penalties and taxes. Yes, this is still money that you could use, but imagine if you let it sit in your 401k and continue to collect money. With retirement savings, it is important to think long-term, even if you are only 20 years old.

The only individuals who should consider an early withdrawal are those considering early retirement, but there are still risks. If 25 and switching jobs, don’t cash out. Wait until you are settled in your new job and apply for a 401k loan. You are doubled taxed, but not charged large fees.

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