By Vincent Barbera, CFP®, MSFS
If you work for a company that offers its employees a 401(k), you have an incredible resource at your fingertips to help you save for retirement. And if you’re lucky, your employer may even throw in some money in the form of matching contributions to make your savings grow even more.
You enroll in the program and diligently save for your future, but then life happens and you need money to cover an unexpected medical emergency or fund a major house repair. It might be tempting to dip into your 401(k) to take care of these needs, but it’s not the wisest move. Here’s why.
Early 401(k) Withdrawal Consequences
It may be comforting to think you have a hefty savings account for the unexpected, but digging into your 401(k) for anything but retirement is definitely too good to be true, even though about 1 in 3 investors have done it. (1) 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 or using the money to pay for certain medical expenses. 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. (2)
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 $60,000 a year, he is taxed 22%, but his withdrawal pushes him into a higher tax bracket for 2019 and he will be taxed 24% instead. On top of that, he lives in Pennsylvania and faces a 3.07% state tax. Here’s the math:
‒ 24% federal tax ($6,000)
‒ 10% early withdrawal penalty ($2,500)
‒ 3.07% Pennsylvania tax ($767.50)
= $15,732.50 total distribution!
That’s a substantial loss. Not only did Michael sacrifice almost $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 Newbridge Wealth Management team is happy to help. Click here to access our online calendar and easily schedule a free 15-minute introductory phone call, or you can email us at firstname.lastname@example.org or call 610.727.3960 to schedule a meeting today!
Vincent R. Barbera, CFP®, MSFS is a managing partner and co-founder of Newbridge Wealth Management, a private financial counseling firm located in Berwyn, Pennsylvania. Believing in a patient, disciplined approach to investment management that delivers value and peace of mind, he utilizes a process-driven approach to financial planning that provides comfort and clarity to his clients’ long-term goals. Along with a bachelor’s degree in psychology and business, he has a master’s degree in business and financial planning and Certified Financial Planner™ designation. Learn more by connecting with Vincent on LinkedIn, or send him questions at email@example.com.