Understanding the risks of early 401(k) withdrawals
While borrowing or taking a distribution from your employer-sponsored 401(k) plan account may be options available to you, you might want to think about the potential negative impact on your long-term goals first.
It's not uncommon to find yourself in a situation where you need access to cash fairly quickly. That's the point at which many people consider taking money out of their employer-sponsored 401(k) plan accounts through either a loan or distribution.
"It's understandable that an individual that needs access to money may consider dipping into their 401(k) plan," says Sylvie Feist, director and retirement management executive, Retirement & Personal Wealth Solutions at Bank of America. "In some circumstances, your 401(k) plan account may be or seem like your only choice for getting access to necessary cash."
A lost opportunity to grow your savings
Here are some things to consider before you look at your 401(k) plan account as a source for meeting your current need. As much as you may need the money now, by taking a distribution or borrowing from your retirement funds, you're interrupting the potential for the funds in your 401(k) plan account to grow through tax-deferred compounding — and that could make it more difficult for you to reach your retirement goals, says Feist. Taking funds out of your plan account might mean missing out not only on the potential growth of the money you have invested but also on any growth of that money's earnings.
"As a general rule, dipping into your retirement funds to cover a short-term need could end up costing you more in the long run. If it's possible, I'd encourage you to consider other ways to access cash that could be more beneficial to your long- and short-term financial goals," Feist says. However, if you're considering a withdrawal from your traditional 401(k) plan account,1 consider the chart below to see the ordinary income tax and early withdrawal additional tax implications before you remove funds from the account. It's important to note that the taxes described below apply only to a true withdrawal. There would be no taxes imposed on funds that you borrow and pay back via a loan (unless you fail to pay it back, as noted below).
What an early withdrawal from a traditional 401(k) plan account could cost you
|
If you're under 59½, you may get hit with both ordinary income taxes and an additional 10% federal income tax.
| Amount of withdrawal |
$25,000 |
| Ordinary income taxes |
-$6,000 |
| Early withdrawal taxes |
-$2,500 |
| What you get: |
-$16,500 |
For illustrative purposes only. All tax calculations herein are merely estimates and should not be relied upon for detailed tax planning purposes.
What happens if you leave your job before the loan is paid off?
Although you generally have up to five years to repay loans from your 401(k) plan account, leaving your job (or losing it) before the loans are repaid may mean you have to pay the money back in full quickly. The amount that still needs to be repaid is now considered a distribution. You may be subject to federal and state income taxes, as well as an additional 10% federal income tax if you are under age 59½, unless an exception applies, Feist adds. However, you may avoid this tax treatment by repaying or rolling over the outstanding loan amount to a new employer's 401(k) plan or an IRA, as long as this is done by the federal income tax filing deadline, including extensions, for the year in which the offset occurred.
For all of these reasons, says Feist, "before you consider taking a loan or a withdrawal from your 401(k) plan account, which may be your only retirement savings, make sure you've explored other options that could meet your needs. Your retirement savings should be your last resort." By tapping into them, you could be impacting your future financial security. An action to consider, if you are able, is to set aside funds for short-term needs, in a separate account, so you have the money available — if and when you need it.
1 Any earnings on Roth 401(k) contributions can generally be withdrawn federally tax-free if you meet the two requirements for a "qualified distribution": 1) At least five years must have elapsed from the first day of the year of your initial contribution or conversion, if earlier, and 2) you must have reached age 59½ or become disabled or deceased. If you take a non-qualified withdrawal of your Roth 401(k) contributions, any Roth 401(k) investment returns are subject to regular income taxes, plus a possible 10% additional tax if withdrawn before age 59½, unless an exception applies. State income tax laws vary; consult a tax professional to determine how your state treats Roth 401(k) distributions.
Depending on the basis of company matching contributions (traditional or Roth, if offered), taxes on these contributions and any earnings on them may be due upon withdrawal. You may also be subject to a 10% additional tax if you take a withdrawal prior to age 59½, unless an exception applies.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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