The Problem with Early 401(k) Withdrawals

When you opt into a 401(k) plan, you agree to deduct a portion of your paycheck and contribute it to the account. You will get to choose a variety of investment options, like stocks and mutual funds, to help the contents of the account grow over time. Your employer might also help you grow your savings even faster by offering matching contributions.

It’s easy to see how your 401(k) can become a significant collection of savings in a short amount of time. Could you rely on those savings before you reach your retirement? Find out why that’s not the wisest financial decision.

401(k) Withdrawals

You are supposed to leave the contents of your 401(k) untouched until you retire. You should at least be 59 ½ years old before you make withdrawals from the savings. The IRS accepts some exceptions for early withdrawals (for instance, people who become permanently disabled).

Otherwise, withdrawing before this minimum age will come with consequences.

Early Distribution Penalty

Most of the time, when you make an early withdrawal from your 401(k), you will have to pay a 10% penalty to the IRS. There are exceptions to this. For instance, during the pandemic, the government passed the CARES Act (Coronavirus Aid, Relief and Economic Security Act), which allowed the penalty to be waived on early retirement account withdrawals.

Taxable Income

In addition to that 10% penalty, the IRS requires an automatic withholding of 20% of early withdrawals for income tax purposes. Now, your withdrawal has shrunk by 30%.

Smaller Safety Net

You’re reducing the size of the nest egg that you’ll need in your golden years when you won’t have a full-time job to bring in a steady income.

What Should You Do Instead?

Before making an early withdrawal from your retirement fund, consider some alternative solutions. There are other ways to cover your expenses.

Use an Emergency Fund

Do you have an emergency fund? Then, this could be the perfect moment to use it. Emergency funds are exceptional safety nets that you can rely on when urgent, unplanned expenses arise. Use it to pay for home repairs, car repairs, veterinary appointments, appliance replacements and more.

You can also turn to this safety net in times of crisis, like if you fall ill or have to take time off work to care for a relative. Use the savings in your emergency fund to temporarily supplement your income until you get back on your feet.

Use Credit

You could turn to credit for help. Charge the expense to your credit card and then pay down the balance later. Or make a withdrawal from a personal line of credit loan and replenish the balance afterward. A line of credit loan can give you access to credit when you need it and when you don’t have enough savings on hand. You should only use this type of loan for emergencies, not everyday expenses.

Take a Loan

If you need to take out a significant sum, you could take out a loan against your 401(k) contributions. You will need to repay the loan before you leave the company sponsoring your 401(k). Leaving before you finish the repayment process will mean you will either have to pay the rest in a lump sum or face the 10% early distribution penalty.

There are better options than making an early 401(k) withdrawal. Leave those savings alone.