The True Cost of Withdrawing Early From Your 401(k)

By Brett Gottlieb

After the challenging couple of years we’ve endured, it’s likely the desire to enjoy a satisfying retirement free from worry has never been higher. Although the ideal retirement might look different from person to person, a common goal is to not outlive our funds after the steady paychecks stop coming in. Achieving this goal is no easy task, but there’s nothing more resourceful than a 401(k) to help you out. And if your employer is contributing funds to grow this nest egg even more, all the better!

Unfortunately, life is unpredictable and sometimes you need cash and you need it now. If you’re tempted to crack open your retirement piggy bank early to cover an unexpected medical emergency or fund a major house repair, it could hurt you. If you are considering cashing out your 401(k) early, consider the following, think twice, and take the time to search for alternatives.

Early 401(k) Withdrawal Consequences

It may be comforting to think you have a hefty savings account for the unexpected, but digging into your retirement accounts for anything but retirement is definitely too good to be true, even though about 51% of investors have done it and 1 in 5 have taken a withdrawal during the pandemic.^[1] But just because others are doing it, remember that this one seemingly simple financial decision can take a huge toll on your future retirement.

Withdrawal Penalties

To motivate us to keep our money set aside for our retirement years, the IRS penalizes 401(k) withdrawals prior to age 59½ by slapping a 10% penalty on the amount you withdraw.^[2] You may have heard about some exceptions to this penalty, such as in the case of a disability or using the money to pay for certain medical expenses.^[3] But before you head to your HR department to start the process, remember that it’s not just the 10% penalty you need to worry about, it’s taxes too.

Tax Penalties

A major perk of contributing to a traditional 401(k) is that you save on taxes now and only pay tax when you withdraw the money in retirement. But if you withdraw the money early, not only will you get taxed on your income earned from working, you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket.^[4] This adds up more than you might realize. Between these two immediate consequences, it’s possible you would only keep less than 70 cents out of every dollar you withdraw early.^[5]

Growth and Goals

Then there are the long-term consequences of cashing out before age 59½. When you save for retirement, you reap the benefits of compound interest, which helps the money you put away grow faster due to interest building upon itself. It means that not only do you earn interest on your principal, but on the interest you’ve already earned as well, so you are earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. This is a critical point that most people lose sight of when they only look at their short-term financial situation.

Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. When you withdraw money that was growing, you put yourself behind on reaching your goals and with less time to build your accounts back up again.

How an Early Withdrawal Could Hurt You

Cashing out a 401(k) may seem harmless, but once you look at the numbers, you can see how much it’ll hurt your pocketbook in the future.

Let’s say Michael (30 years old) withdraws $25,000 from his 401(k) to pay off student loans. Since he earns $70,000 a year, he is taxed 22%, but his withdrawal pushes him into a higher tax bracket for 2022 and he will be taxed 24% instead.^[6] On top of that, he lives in California and faces a 9.3% state tax.^[7] Here’s the math:

$25,000 distribution

‒ 24% federal tax ($6,000)

‒ 10% early withdrawal penalty ($2,500)

‒ 9.3% California tax ($2,325)

= $14,175 total distribution!

That’s a substantial loss. Not only did Michael sacrifice more than $10,000 at the front end, but he also forfeited the compound interest on the $25,000, an amount that could take him years to invest again.

An Alternative Option

If you ever find yourself in a tough spot financially and are considering cashing out your 401(k), it’s more than worth it to speak to a financial advisor before making any rash decisions. It may turn out that you have other, less financially devastating options available to you, such as taking out a loan on your 401(k) or taking a hardship withdrawal.

Whether you have questions about cashing out your 401(k) or you’re interested in creating a personalized financial plan to help reach your goals, the Comprehensive Advisor team is happy to help. Email us at info@ComprehensiveAdvisor.com or call (760) 813-2125 to get started.

About Our Advisors

Brett Gottlieb is the founder of Comprehensive Advisor and a financial advisor with nearly two decades of industry experience. He graduated from California State University-Chico with two bachelor’s degrees in Business Administration and Economics. Brett is Life Insurance licensed in several states. He is passionate about guiding his clients on retirement income planning, helping each client pursue their specific retirement goals and defending the assets his clients have worked so hard to achieve. Brett is a California native and currently resides in San Elijo Hills with his beautiful wife and three children.

With a combined experience of over three decades in the financial services industry, our advisors hail from some of the largest independent broker/dealers and banking institutions in the country. They have dedicated their professional careers to creating personalized financial solutions for individuals and families who seek successful retirement planning and currently offer investment advisory services through AE Wealth Management, LLC. Our advisors take a common-sense approach to the planning process and work with clients to create a retirement road map to help ensure their assets are protected and they receive the income needed to enjoy their future. Based in Carlsbad, California, they work with clients throughout San Diego County and beyond. Learn more by connecting with Brett on LinkedIn or email them at info@ComprehensiveAdvisor.com.

Comprehensive Advisor, LLC is an independent financial services firm that utilizes a variety of investment and insurance products. Investment advisory services offered only by duly registered individuals through AE Wealth Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and Comprehensive Advisor are not affiliated companies. C.A. Financial & Insurance Services, CA Ins. Lic. #6000262. This material is intended to provide general information and is believed to be reliable, but accuracy and completeness cannot be guaranteed. Neither the firm nor its representatives may give tax or legal advice. Investing involves risk, including the potential loss of principal. Any references to protection benefits, safety, security, lifetime income, etc. generally refer to fixed insurance products, never securities or investment products. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.  1251313 – 3/22

^[1] https://www.bankrate.com/retirement/retirement-savings-survey-november-2021/

^[2] https://www.nerdwallet.com/article/investing/early-withdrawals-401ks#:~:text=If%20you%20withdraw%20money%20from,%247%2C000%20from%20your%20original%20%2410%2C000

^[3] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

^[4] https://www.moneyrates.com/investment/alternatives-to-early-401k-withdrawal.htm

^[5] https://www.moneyrates.com/investment/alternatives-to-early-401k-withdrawal.htm

^[6] https://www.bankrate.com/taxes/tax-brackets/

^[7] https://www.nerdwallet.com/article/taxes/california-state-tax