401k Early Withdrawal
Is a 401k early withdrawal a good choice that you should make with your retirement money? That is a common question that many people ask, especially in these financially tight times. While the purpose of a 401k or Roth 401k is to properly fund your retirement, more and more people are turning to their retirement funds as another source of money to pay for bills and sustain their current level of living.
But, what can you expect if you have a 401k early withdrawal? What are the taxes on a 401k early withdrawal? How will the 401k early withdrawal penalties affect your overall retirement planning picture?
The 401k is a great plan that if used wisely will accumulate money over the long term for your retirement. There are several considerations that must be thought about if you are considering having to tap into your 401k. The main principal that must be remembered about the 401k, or any long term retirement plan, is the principal of compounded interest. So, let’s take a look at a quick and simple example to explain compounded interest.
If you invest a mere $5,000 into a 401k to start, after 30 years at 6% your initial $5,000 will grow into around $30,000. However, if your rate of return is 12%, which isn’t unheard of with 401k plans, you would have around $180,000. That is a $150,000 difference!
So, if you tap into your 401k plan for a short term fix, you are effectively limiting your return on your investment by interrupting the compounded interest you would earn on your money.
There are certain penalties that a 401k early withdrawal would also incur. Not only would you have to pay an immediate 10% penalty of any money that you withdrawal, but you will also pay taxes on that money as well based upon your current tax rate. How does that work?
Well, if you were to request a withdrawal of $20,000 from your 401k, you would pay an immediate $2,000 penalty for it. So, you are left with $18,000. Now, you might not think that is to bad, but, you will still have to pay taxes on that money just like it is regular income. So, when you pay your taxes, let’s say a conservative 28% tax bracket, you will pay $5,600 in taxes on it!
So, to take $20,000 from a 401k early withdrawal, you will pay around $7,600 in taxes and penalties. If you look at the earlier example, you have just paid more than your “initial investment” to have your own money! If you are willing to throw that kind of money away, please let me know, I’ll take it! Just kidding…
While the 401k early withdrawal penalties are pretty steep and heavy with taxes, if you really need to access your retirement funds, there are options that you can explore. You could use a 401k loan, which means that you are borrowing against your 401k account. You will have the funds without the penalties and taxes, however, you will be responsible for paying it back.
While a 401k early withdrawal might seem like the only option to consider during a financial crisis, there are several other options that will not affect your long term retirement planning as severely. Knowing these options and how the 401k early withdrawal penalties and taxes will affect you will give you guidance in saving the most money for your retirement.
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If you are new to a 401k, looking into getting a 401k, or just curious about how it might fit into your retirement package, then you have come to the right place.
Thanks for the great example! I was getting ready to pull some money out and now I think I will reconsider! With gas prices so high, maybe I’ll just sell the boat.
[...] During a market downturn, or recession, many financial “gurus” will tell their clients and self directed financial geniuses to dump their 401k and put their money into other investments such as bonds or CD’s. This can create several bad consequences, not to mention the 401k early withdrawal tax issues. [...]