Money can get tight and emergencies happen. When you’ve built up a nest egg for yourself in a 401(k), It can be tempting to want to dip into those savings. In most cases, however, you should exhaust every other option before you do. Why?
401(k) penalties
If you’re younger than 59½, you’ll pay an additional tax penalty of 10% of the funds you withdraw. That’s a big penalty. If you withdraw $20,000 from your 401(k), for example, you will immediately lose $2,000 in tax penalties.
Note: the 10% penalty can be waived if you become permanently unable to work due to disability. There are also some variations on this rule for people who leave their employer after age 55 or who work in the public sector. Most people taking an early withdrawal from their 401(k), however, can expect to sacrifice 10% of the funds they withdraw this penalty. Not to mention missing out on the compound interest you would have if you would have left that money alone.
401(k) taxes
Remember, the contributions you make to your 401(k) plan come out of your paycheck before you pay taxes on that income. In fact, that tax savings is one of the major benefits of using a 401(k). When you take a withdrawal, however, those funds count as income for the current year. You will have to pay any federal and state income tax on those funds the same as you would for any other income.
Lost employer contributions
If your 401(k) is provided by your employer, and your employer contributes to your retirement savings, you may lose some of those funds if you make an early withdrawal. Some employers use vesting schedules for contributions they make for their employees. Basically, even though the employer contribution shows up in your account, you don’t actually own those funds—and you can’t use them or take them with you to a new job—until you’ve worked a certain amount of time for your employer.
Say you’ve contributed $5,000 to your 401(k), and your employer matched that contribution, contributing an additional $5,000 to your retirement savings. Your 401(k) account balance may show $10,000, but if you’re only 30% vested, you only own 30% of that employer contribution: $1,500. So, the real total you can access is just $6,500. If you take an early withdrawal, in addition to taxes and penalties, you also lose the portion of your retirement savings that isn’t vested (in the case of thisexample, $3,500).
Lost growth
The biggest reason to avoid taking an early withdrawal from your 401(k) is that by withdrawing moneynow, you are losing out on all of the interest that money would earn if you left it in your 401(k) until you retired. As a very basic example, if you had $5,000 in your 401(k) today, and it grew at an average rate of 5% per year, it would be worth $10,441 in 20 years—more than double. If you withdraw those funds early, however, you’re not only facing a stiff tax penalty, you’re losing all of that additional growth.
