There are a number of reasons why it might be tempting to cash out your hard-earned 401k savings before retirement. From hefty car or home repairs to emergency medical expenses, sometimes unexpected circumstances cause us to seek out extra cash. In fact, 1 in 3 people have resorted to a 401k early withdrawal, often when in between jobs.
However, it’s important that you’re aware of any penalties and fees before you choose to withdraw. Additionally, 401k early withdrawals may have unwanted impacts on your taxes. Read on to learn exactly what happens when you decide to dip into your 401k so you won’t be surprised by any repercussions.
What Happens When You Make a 401k Early Withdrawal
A normal, penalty-free 401k withdrawal occurs after retirement or after you’ve reached the age of 59½. The funds are subject to income tax just like your paycheck previously was. However, if you choose to withdraw funds before the age of 59½, there will be penalties.
Every early 401k withdrawal is subject to income tax as well as a 10% early withdrawal penalty tax. You can cash out up to 100% of your 401k early, but depending on your tax bracket, this could cause you to lose almost half of your savings. Additionally, you’ll lose out on potential future savings growth.
When it’s time to file taxes, you’ll owe more because your taxable income has increased. If your withdrawal was substantial, it may even push you into a new tax bracket, causing you to owe even more to the IRS.
Let’s say you choose to make an early 401k withdrawal of $50,000. Consider the following hypothetical taxes (yours will vary depending on your state and income bracket):
- Federal income tax of 25% = $12,500
- State income tax of 7% = $3,500
- Penalty tax of 10% = $5,000
This leaves you with a meager $29,000 left—a little over half of what you started with. This early 401k withdrawal calculator will give you a better grasp on your specific numbers.
Exceptions to 401k Early Withdrawal Penalties
Withdrawals made under the age of 59½ will not be subject to the 10% early withdrawal tax under any the following circumstances:
- You pass away and the funds are withdrawn by your chosen beneficiary
- You become permanently disabled
- You terminate employment and are at least 55, or 50 if you work for the government
- You withdraw an amount less than is allowable as a medical expense deduction
- Your withdrawal is related to a Qualified Domestic Relations Order after a divorce
- You begin a series of “substantially equal payments” — learn more here
- You are a qualified military reservist called to active duty
Additional Considerations Before You Withdraw
If you’re in a pinch and need to use your 401k savings, an alternative to an early withdrawal is to take out a loan from your 401k. If your plan allows it, it could have significantly less of an impact on your retirement savings, given you pay it back. If you fail to repay the loan plus interest, it will be treated like an early withdrawal, and you’ll be subject to the penalties.
Another option to keep your savings intact is to roll them over into a traditional or Roth IRA account. If you’ve left a job and don’t know what to do with your 401k, this is a good option. A direct rollover is ideal, because your plan writes the check directly to your IRA. If you choose an indirect rollover, your plan writes the check to you, but the process is more complicated. Consult your financial advisor if you’re ever unsure.
Because of the many roadblocks to 401k early withdrawals, you may find you want to keep away from your 401k until you’re retired — just be sure to consult your financial advisor if you’re ever unsure. Remember that diligently contributing to your 401k now will set yourself up for a happier, less stressful retirement. Because when that time comes, you’ll have earned the right to spend less time worrying about money and more time sipping mai tais on the beach.
Sources: IRS | Fidelity | Wells Fargo