You might think the subject of this post is an obvious concept, but you would be surprised how many 401(k) early withdrawal requests cross my desk that are simply meant to cover unexpected expenses. This is truly why I felt the need to write about this topic.
Your 401(k) is designed to help you live comfortably later in life. The funds are meant to be set aside, allowed to grow and not touched. Beyond this, you need to build up other savings to help you cover your day‑to‑day existence.
There are financial consequences when you access your 401(k) savings prematurely ranging from penalties, to taxes and opportunity costs. Here are some concrete examples as to why you should not access your retirement savings for short‑term needs.
1)The Purpose and Penalties
A 401(k) is meant and designed to be retirement savings. It allows you to set aside money pre‑tax which means it reduces your gross wages subject to tax. For example, if you earned $100,000 but contributed $10,000 to your retirement plan, you will only be taxed on $90,000.
To help you prepare for a successful retirement, many employers will offer a match on what you contribute. As an example, my employer matches 25% of every dollar I contribute. In the example above, that $10,000 contributed to a 401(k) would have an additional $2,500 added to the plan. That represents 25% growth on your savings right out of the gate.
Your 401(k) plan is meant to improve your quality of life in retirement so accessing those funds early comes with a price.
Because your 401(k) contributions come with tax advantages, accessing them early comes with penalties. Early withdrawals often come with a 10% penalty if you access retirement savings before the age of 59½.
Additionally, you are going to have to pay income tax on any money you take out.
In the example above you didn’t pay income tax on $10,000. If you pull any of those funds early, you lose that benefit and will now have to pay taxes. Let’s say you pull out the full $10,000 set aside in the example above. You are only going to receive $9,000 because of the penalty and you now owe income tax on the amount withdrawn, so you better set some of those funds aside to cover your tax bill come April 15.
2)Lost growth opportunity
Compound growth is a big advantage of contributing to a 401(k) or any investment vehicle.
If you pull money out of your 401(k) plan, you lose the opportunity to grow those funds.
Sticking with the example above, let’s assume you pull out $10,000. In addition to the penalty and the income tax, you are now going to lose the growth opportunity on $10,000.
If you assume an average of 5% growth per year, that $10,000 would grow to approximately $16,300 after 10 years. After 20 years, it would be approximately $26,500.
Depending on where you are in life, 10 and 20 years may sound like a long time but that is the point of contributing to a retirement plan. Set it aside, forget about it and let it grow.
3)Delayed Retirement
This is an obvious conclusion to the above discussion but I want to make sure to bring home the point that relying on your 401(k) plan for short‑term needs will harm your ability to retire when you want.
This problem is prevalent in our society. Very few people really understand how much money is required to retire comfortably thus most people do not have enough retirement savings.
In various surveys you will see that only 40% of Americans feel good about their retirement savings and roughly 40% of American workers are behind on retirement planning and savings.
Conclusion
Contributing to your 401(k) plan is a critical part of retirement planning. Give what you can now, increase that contribution as your earnings increase over the years and let it grow.
You should not treat your 401(k) plan as a regular savings account but instead build a budget that allows you to save for both planned and unexpected expenses.
Ideally you want to build a separate emergency fund that will cover 3‑6 months of living expenses.
If you don’t think this is important, just think about all the lives impacted by the pandemic. I continued to work but many people lost their source of income for a period of time or altogether.
I would keep this emergency savings out of reach as well. Do not make it easy to access so that you allow it to grow. It may take time but with some discipline you can get it done.
Then when that unexpected situation arises, you won’t have to tap into your 401(k) and you can live that comfortable life once your working career comes to a close.
Frequently Asked Questions About 401(k) Withdrawals
Can you withdraw money from a 401(k) early?
Yes, you can withdraw money from a 401(k) early, but it usually comes with financial consequences. Most early withdrawals before age 59½ come with a 10% penalty and the money withdrawn is also subject to income tax.
What happens if you withdraw money from a 401(k) early?
When you withdraw money from a 401(k) early, three things usually happen. First, you pay a 10% early withdrawal penalty. Second, the withdrawal becomes taxable income. Finally, you lose the future investment growth that money could have earned.
Are there situations where a 401(k) withdrawal makes sense?
There are limited situations where accessing retirement savings may be unavoidable, such as severe financial hardship or certain medical situations. Even then, it is important to understand the tax and penalty implications.
What is the best way to avoid withdrawing from a 401(k)?
The best way to avoid tapping into retirement savings is to build an emergency fund. Ideally you should have three to six months of living expenses saved in a separate account so unexpected expenses do not disrupt your retirement savings.
