There are multiple reasons why you might consider taking an early withdrawal from your 401(k) — a desire to reduce your debt load by paying off credit cards or your car loan, etc.; a need for emergency funds; or simply that you’re changing jobs and closing out the 401(k) from your old company.
However, there are serious consequences to taking this money out of your tax-advantaged retirement plan and you should consider them before making your decision.
You didn’t pay taxes on this money before it went into your 401(k), so the IRS will be looking for its due when you withdraw it. But don’t think they are going to wait until April 15th. Your plan administrator is typically required to automatically withhold 20% of your withdrawal and send it directly to the IRS to cover your federal income tax bill. And you may still owe additional federal taxes (depending on your tax bracket) plus state and/or local taxes, come April. Clients should check with their tax advisor about potential downsides such as these.
If you take a withdrawal prior to age 59 ½, you will be subject to a 10% early withdrawal penalty, unless an exception applies. Your withdrawal is likely going to look considerably smaller than you expected, after taxes and penalties are subtracted. In fact, if you’re in the top tax bracket, it could end up being close to 50% smaller.
What you may lose, most of all, is the opportunity for tax-deferred earnings on the amount you withdraw. The further you are from retirement, the more potential future income you may be missing out on.
You are probably aware that the power of tax-advantaged accounts such as 401(k)s is that they enable your tax-deferred contributions to grow, free of the erosion of taxation. Contributions may generate earnings, and the accumulation may gather pace over time. Losing this growth opportunity could dramatically lessen your income in retirement.
If your plan allows it, you can take a loan from your 401(k) and pay yourself back with interest. Note that you will still lose the potential long-term earnings on this money — and this is not a minor consideration — but at least you won’t have to pay taxes and penalties. The IRS limits the maximum amount you can borrow to $50,000 or half the amount you have vested in the plan, whichever is less. In most cases, the loan term is five years.
The cons include the inconvenience of knowing that repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account. However, probably the worst-case scenario with a 401(k) loan is leaving or losing your job. You may have to pay the loan back in full within 90 days or report the outstanding balance as income. Reporting it as income will trigger tax and penalty payments.
Some people may simply take a distribution from their old 401(k) when they switch jobs and end up losing much of the savings they’ve worked hard to accumulate. There are easy ways to prevent this. Most plans will let you leave your money right where it is. However, you lose the ability to add any more contributions or take advantage of matching contributions.
A better alternative is to request a direct rollover to an individual retirement account (IRA). A direct rollover means the distribution check will be sent directly to the new IRA, not to you. As a result, you avoid the 20% tax withholding that happens when the check is sent to you, even if you plan to deposit it in another tax-advantaged plan.
(And if you don’t replace that 20%, the IRS can call the difference between what you took out of your 401(k) and what you put into your IRA a withdrawal, even though they are the ones who have it.)
There are other common mistakes people make with a 401(k), besides making withdrawals without thinking carefully about the consequences.
Every part of your financial life requires objective decisions based on in-depth knowledge. Taking action around big life events is important, but avoiding small mistakes can also be key to having the life you want.
At United Capital, we’re dedicated to helping you achieve that life by making intentional decisions every step of the way. Any of our dedicated advisors can guide you through the lifelong process of making your money do its best for you. We also encourage people to meet with their tax advisor.
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