It’s no secret that most of us dream of living out our golden years in a secure and fulfilling retirement. And there’s nothing more resourceful than your trusty 401(k) to help you inch closer to that goal. If your employer is contributing funds to make this nest egg grow even more, all the better!
Unfortunately, life is unpredictable and sometimes you need cash and you need it now. If you’re tempted to crack open your retirement piggy bank early to cover an unexpected medical emergency or fund a major house repair, it could hurt you. If you are considering cashing out your 401(k) early, consider the following, think twice, and take the time to search for alternatives.
Early 401(k) Withdrawal Consequences
It may be comforting to think you have a hefty savings account for the unexpected, but digging into your retirement accounts for anything but retirement is definitely too good to be true, even though about 14% of investors have done it (1) and more than 1 in 4 have taken a withdrawal during the pandemic. (2) But just because others are doing it, remember that this one seemingly simple financial decision can take a huge toll on your future retirement.
To motivate us to keep our money set aside for our retirement years, the IRS penalizes withdrawals prior to age 59½ by slapping a 10% penalty on the amount you withdraw. You may have heard about some exceptions to this penalty, such as in the case of a disability, using the money to pay for certain medical expenses, or taking advantage of the 2020 CARES Act penalty waiver. But before you head to your HR department to start the process, remember that it’s not just the 10% penalty you need to worry about, it’s taxes too.
A major perk of contributing to a 401(k) is that you save on taxes now and only pay tax when you withdraw the money in retirement. But if you withdraw the money early, not only will you get taxed on your income earned from working, but you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket. This adds up more than you might realize. Between these two immediate consequences, most people get to keep less than 70 cents out of every dollar they withdraw early. (3)
Growth and Goals
Then there are the long-term consequences of cashing out before age 59½. When you save for retirement, you reap the benefits of compound interest, which helps the money you put away grow faster due to interest building upon itself. It means that not only do you earn interest on your principal, but on the interest you’ve already earned as well, so you are earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. This is the critical point most people lose sight of when they only look at their short-term financial situation.
Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. When you withdraw money that was growing, you put yourself behind on reaching your goals and with less time to build your accounts back up again.
How an Early Withdrawal Could Hurt You
Cashing out a 401(k) may seem harmless, but once you look at the numbers, you can see how much it’ll hurt your pocketbook in the future.
Let’s say Michael (30 years old) withdraws $25,000 from his 401(k) to pay off student loans. Since he earns $70,000 a year, he is taxed 22%, but his withdrawal pushes him into a higher tax bracket for 2021 and he will be taxed 24% instead. On top of that, he lives in California and faces a 9.3% state tax. Here’s the math:
‒ 24% federal tax ($6,000)
‒ 10% early withdrawal penalty ($2,500)
‒ 9.3% California tax ($2325)
= $14,175total distribution!
That’s a substantial loss. Not only did Michael sacrifice more than $10,000 at the front end, but he also forfeited the compound interest on the $25,000, an amount that could take him years to invest again.
An Alternative Option
If you ever find yourself in a tough spot financially and are considering cashing out your 401(k), it’s more than worth it to speak to a financial advisor before making any rash decisions. It may turn out that you have other, less financially devastating options available to you, such as taking out a loan on your 401(k) or taking a hardship withdrawal.
Whether you have questions about cashing out your 401(k) or you’re interested in creating a personalized financial plan to help reach your goals, the HBA Wealth team is happy to help. Contact us at (626) 529-8347 or email Ricky directly at firstname.lastname@example.org to schedule a meeting today!
About Haydel, Biel & Associates
Haydel, Biel & Associates is an independent financial advisory firm serving individuals and families near Pasadena, California. The firm was founded in 2004 by Chris Haydel and Ricky Biel with a desire to provide unbiased, client-centered, community-based financial advice. Together, they have built a practice that has grown into a family of caring, smart professionals committed to blending proven investment methodologies with creative financial technologies that make it easier than ever to accomplish your goals. They strive to keep things simple and fun to give their clients peace of mind and alleviate financial stress. HBA Wealth takes care of their clients’ needs first and foremost and goes the extra mile to make their clients’ finances grow. To meet and see how the HBA Wealth team may be able to help, contact them today at (626) 529-8347 or email Ricky directly at email@example.com.
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