How early 401(k) withdrawals can mess up your finances

Frustrated couple reading documents and wondering how they can avoid a 401(k) tax on the withdrawal they made from their retirement account Frustrated couple reading documents and wondering how they can avoid a 401(k) tax on the withdrawal they made from their retirement account Image:

In a Nutshell

Saving for retirement is a good thing. But making an early withdrawal from your 401(k) can seriously affect your finances. You could face income tax and penalties on the amount you withdraw, plus you miss the opportunity to keep that money growing in a tax-advantaged account.

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It’s easy to understand why people contribute to 401(k)s – and why you might want to as well.

They do it to secure their financial futures and to take advantage of some nifty tax benefits. What might be harder to understand is why anyone would take money out of their 401(k) before they retire.

Maybe they face a financial crisis — like a big, unexpected tax bill — and a 401(k) loan seems like an easy way to get some low-interest money. Or they leave a job and figure it’s easier to just cash out their old 401(k) than go through the process of moving it. They may think the amount in the account is small enough that any negative financial impact will be small, too.

But making early withdrawals from a 401(k) — for any reason and in any form — can seriously affect your finances. Before you go there, it’s important to understand the rules for early withdrawals and 401(k) loans, and how they can affect your taxes.


What happens if I withdraw money from my 401(k)?

When you participate in a 401(k) plan, the money you defer from your paycheck into the account isn’t included in your taxable income. This helps reduce your federal income tax bill during your working years when your income typically is higher than during retirement. Of course, that’s if you follow federal rules for how much you can contribute to the account each year, and when you can remove the money without a penalty.

Taking an early withdrawal from a retirement account — or taking cash out of the plan before you reach age 59½ — can trigger income taxes on the amount, along with a penalty.

At the end of the year, the plan administrator issues a Form 1099-R reporting the distribution, sending a copy to you. The withdrawn amount is considered taxable income and will be taxed at the ordinary income tax rate.

But that’s not all.

“Withdrawing the funds creates a nasty tax bomb,” says Ryan Fisher, a certified financial planner with White Coat Wealth Management in Fort Wayne, Indiana. “Not only will you have to pay income tax on the withdrawal, but in addition to that, you’ll be assessed a 10% penalty.”

And you’ll likely have to report that early withdrawal penalty — also called an additional tax on withdrawals — on Form 5329, attaching it to your tax Form 1040 when filing your annual tax returns.

Learn more about the new Form 1040

Other ways early withdrawals can affect finances

If the federal taxes and penalties aren’t bad enough to deter you from taking an early withdrawal, consider other ways in which cashing out your retirement accounts could affect your finances.

Loss of retirement savings

If you’re young and your 401(k) balance is small, you may believe that it’ll be easy to make up the loss of retirement savings that occurs when you cash out your 401(k). You might think you’ll just make a little larger investment later to regain your footing.

But that logic overlooks one important factor: the power of compounding.

The power of compounding refers to the snowball effect that happens when your earnings generate more earnings not just on the principal investment, but on the interest accrued as well.

For example, say you invest $50 this month and earn 5% interest, or $2.50. Your new balance is $52.50. The next month you earn 5% of $52.50, or $2.63. Your new balance is $55.13. If you continued saving $50 every month and earning 5% interest, in 30 years you could have $40,079.41.

What would happen if you waited 15 years but doubled your contribution? If you invested $100 every month for 15 years, earning 5% interest per year, you’d have only $26,102.17 at the end of 15 years.

So even doubling the monthly amount you save later might not be enough to make up for the lost years of retirement savings now. Even a small amount of early withdrawal, or 401(k) distribution, now can potentially set your retirement savings back considerably.

Costly tax bill

We’ve already covered 401(k) tax on withdrawals, but there’s another aspect of the tax consequences you might not have considered. You may have big plans to use that 401(k) money to start a business, pay off debts or put it toward another purpose. But once the money is spent, how will you be able to pay your tax bill on the amount taken out?

Tax laws require plan administrators to automatically withhold 20% of your withdrawal for the IRS. That amount may partially cover the tax on the early withdrawal but may not be enough.

If you can’t afford to pay the entire tax bill by the due date, then you may have to pay your tax bill with a credit card, set up an IRS installment plan or get a personal loan — all of which can end up costing you more in interest.

Are there any good reasons to take an early 401(k) withdrawal?

While taking an early withdrawal from your 401(k) will rarely be an ideal option, sometimes you might feel it’s your only one. The IRS recognizes there might be times when you legitimately need the money early. It has made some exceptions to the 10% penalty on early withdrawals, including the following:

• Paying for medical expenses not reimbursed by health insurance that exceed 7.5% of your adjusted gross income, or AGI
• Paying for qualified higher education expenses
• Payment made toward buying a first home, capped at $10,000
• Total and permanent disability of the account owner
• Payments made to a former spouse under a qualified domestic relations order
• Distributions paid to qualified military reservists called to active duty
• Payments made when an employee separates from service during or after the year when the employee reaches age 55 (age 50 for certain public safety employees in a government defined-benefit plan)

In these situations, you may still owe ordinary income tax on the distribution, but you can avoid the additional 10% 401(k) tax on withdrawals.

But what if you use the funds to pay off debt or start a business — actions that could save you money or create additional income in the future? It’s not usually in your best interest to use a 401(k) to pay off debt, according to Fisher.

“IRAs and 401(k)s naturally have bankruptcy protection built into them,” he says. “I would exhaust all other options before making that decision.”

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, money in qualified retirement accounts — like 401(k)s — typically can’t be seized in bankruptcy. So even if your financial situation is so dire it leads to bankruptcy, the money in your 401(k) is safe, as long as you leave it in your 401(k).

The same reasoning applies to cashing out a 401(k) to start a business. “I’ve seen successful businesses that were started with 401(k) funds, but it’s a very risky maneuver given the historical success rate of businesses in the first five years,” Fisher says.

How did tax reform affect 401(k) loans?

What should I do with my old 401(k) instead?

If you have an old 401(k) with a former employer, several alternatives to liquidating your 401(k) can help you avoid paying taxes on that money right now and keep your savings growing. Here are some options.

Direct rollover into a traditional IRA. Open a traditional individual retirement account and request your old 401(k) plan administrator to make a direct rollover of your entire 401(k) balance into the IRA. In a direct rollover, the check is made payable directly to your IRA, so you don’t have to pay taxes on it.
Indirect rollover into a traditional IRA. In an indirect rollover, the check is made payable to you rather than to your IRA, and you must deposit the money into the IRA within 60 days. Otherwise, the amount may be considered an early withdrawal and be taxed accordingly.
Roth conversion. You may choose to roll your 401(k) into a Roth IRA after considering the tax implications. With a Roth IRA, you make contributions with after-tax money, but the distributions are tax-free in retirement. So, in a rollover, you’ll have to pay taxes on any pretax contributions made to your 401(k) in the year you roll over your early withdrawal funds. This can be a good thing if you believe you’ll be in a higher tax bracket in retirement and prefer to pay the income tax on the rollover at a lower rate now. However, the decision is complex, so before making a Roth conversion, it’s a good idea to discuss it with a financial adviser or tax professional.
Roll over your balance into your new employer’s 401(k). Once you’ve enrolled in the 401(k) at your new employer, you may be able to roll your old 401(k) balance into your new employer’s plan. This can make it easier to keep track of your retirement savings balance because it will be in one plan and it will grow tax-deferred. However, first compare plan fees, expenses and investment options with those on an IRA to see which option would be better.
Leave your money where it is. Leaving your employer doesn’t necessarily mean you need to quit the retirement plan. Many plans allow employees to keep their money in the plan after they leave, so talk to your plan administrator to see if this option is available. Keep in mind, though, that you won’t be able to make new contributions to the plan or benefit from any employer-match program.


Bottom line

It might be tempting to cash out your 401(k) balance when you leave a job, but it’s rarely a smart financial move. Even if the balance is small, draining the account can leave you with a big tax bill and severely impact your retirement savings.

Whenever possible, roll over the old 401(k) into an IRA or to a new 401(k), or just keep it in your old plan. That way, you’ll keep your savings intact, continue benefitting from the tax-advantaged growth these plans allow, and have much more savings accumulated by the time you need to start making withdrawals during retirement.