The True Cost of Withdrawing Early From Your 401(k)

By Chris Palabe, CFS®, AIF®

After the challenging couple of years we’ve endured, the desire to enjoy a satisfying retirement free from worry has never been higher. Although the ideal retirement might look different from person to person, a common goal we all share is to not outlive our funds after the steady paychecks stop coming in. Achieving this goal is no easy task, but there’s nothing more resourceful than a 401(k) to help you out. If your employer is also contributing funds to this nest egg, all the better!

As we all know, life is unpredictable and sometimes you need cash right away. But if you’re tempted to crack open your retirement piggy bank early to cover an unexpected medical emergency or fund a major house repair, this could hurt you. If you find yourself in this situation, our advice is to 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 too good to be true. More than half of investors have done this and 1 in 5 people have taken a withdrawal during the pandemic [1]; but just because others are doing it doesn’t mean it’s a wise choice for you. It’s important to remember that this one seemingly simple financial decision can take a huge toll on your future retirement.

Withdrawal Penalties

To motivate us to keep our money set aside for our retirement years, the IRS penalizes 401(k) withdrawals prior to age 59½ by slapping a 10% penalty on the amount withdrawn. [2] 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. [3] 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 the taxes too.

Tax Penalties

A major perk of contributing to a traditional 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, you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket. [4] This adds up more than you might realize. Between these two immediate consequences, it’s possible you would only keep less than 70 cents out of every dollar you withdraw early. [5]

Growth and Goals

There are also 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. This means you not only 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 a critical point that 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 2022 and he will be taxed 24% instead.[6] On top of that, he lives in California and faces a 9.3% state tax.[7] Here’s the math: 

$25,000 distribution

‒ 24% federal tax ($6,000)

‒ 10% early withdrawal penalty ($2,500)

‒ 9.3% California tax ($2,325)

= $14,175 total 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 Palabe Wealth team is happy to help. Schedule a 15-minute introductory phone call or call us at 847-249-6600 to learn if we are the right fit for your financial goals.

About Chris

Chris Palabe is the founder and CEO of Palabe Wealth, a financial services firm providing retirement plan strategies for businesses and individuals. For 25 years, Chris has been serving his clients with customized plans and a boutique approach. He started his firm because of his passion for making a difference in others’ lives and a genuine desire to build long-term relationships with his clients so they can seek to achieve their ideal retirement and manage risk. Chris is a Certified Fund Specialist® (CFS®) and Accredited Investment Fiduciary® (AIF®) professional and has a degree from Université Denis Diderot (Paris VII). When he’s not working, you can usually find him riding horses and competing in dressage at a national level. He also loves reading, watching movies, and eating out. To learn more about Chris, connect with him on LinkedIn.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

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[1] Bankrate November 17, 2021

[2] Nerdwallet March 2, 2022

[3] IRS April 7, 2022

[4] MoneyRates April 14,2022

[5] MoneyRates April 14,2022

[6] Bankrate April 7, 2022

[7] Nerdwallet March 2, 2022