401k Withdrawals – Beneficial or Costly Mistake?

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The inspiration for this post came from an article I read recently about people tapping into their 401k funds.

When it comes to you 401k, have you ever wondered what should you be mindful of while you are still at your job?

The purpose of a retirement account, like a 401k, is to provide you with income at retirement. You have to be careful about how you use and treat the money in your 401k in all the years before you retire.

When the time comes for you to stop working, you’d like to have as much cash on hand as possible, so you can have a cushy or at least comfortable retirement.

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To reach that goal, you need to keep your money active in the market for as long as possible to see the growth that comes from compounding interest.

As you accumulate money in your 401k, there may be a time when you are tempted to take out some of those funds.

You are allowed to do the following with your account funds:

  • Take out up to half of the balance
  • Cash out the balance when you leave that company
  • Take loans against the account

While you have the liberty to do any of the above, it’s highly advisable that you do NOT do any of them!

Here is why:

Taking out the funds before you leave the job

Remember the goal in your pre-retirement years is to be accumulating funds. This money is for your later years. It’s not another savings account. You want to grow your account balance not reduce it.

Any withdrawal that happens prior to you being 59 ½, will result in you paying federal and state income taxes and a 10% early withdrawal penalty.

Cashing out when you leave the company

As you can see below this is most common with people in their 20s and 30s.

This is similar to the first option, but worse. When you leave your job, you have a few options of what you can do with these funds.

What you don’t want is to take it all as cash.

You will have to pay taxes and a penalty for withdrawing the money, but you’ve also drawn the bucket for your retirement down to $0, essentially wasting all those years of making contributions.

Also, your employer will automatically withhold 20% and send it to IRS to cover the taxes you’ll need to pay.

You can see the money disappearing, right?

Example. If your 401k balance is 18,000. You’ll

  • Pay $3,600 to federal and state taxes
  • Pay $1,800 for early withdrawal
  • The amount you’ll receive = $12,600

Taking a loan against the account

Loans can be taken for up to 50% of your vested balance to buy a home or for hardship situations, like preventing foreclosure, or paying college expenses.

Emergencies do come up in life, but ideally they shouldn’t be funded by borrowing money from your retirement funds.

You should first opt to fund the emergency from your emergency fund, savings account or even a loan outside of your 401k.

Do you have a plan for paying back that loan?

  • If you don’t pay for 90 days, the loan is treated as a distribution, so you’ll have to pay taxes and early withdrawal penalty on the outstanding amount
  • Your required repayments will come directly from your paycheck, so most borrowers need to reduce their 401k contributions going forward while repaying their loans
  • If you get laid off or quit your job, the remainder of the loan is due within 60 days

I recognize there are always extenuating circumstances that could cause you to need to use these funds despite what I’ve explained above.

At the end of the day, all the contributions you’ve made to that account is your money. Just be careful not to view your 401k as a cash machine.  Taking any of these cash out options will have a negative impact on your retirement savings.

The Center for Retirement Research estimated that tapping retirement funds early reduces wealth in US retirement accounts by about 25%.

 

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