One of the most frustrating aspects of a 401(k) retirement plan is the length of time you need to wait before withdrawals. 401(k) early withdrawal fees can eat away at the gains you’ve made and eliminate meaningful growth from your account. Still, that doesn’t exactly mean it’s never a good idea.
The minimum age for 401(k) withdrawals without penalty is 59.5. Especially for young investors, that can be a long time to wait for your money. Under the right circumstances, taking the penalty can make sense, but you need to understand both the penalties you will incur and the benefits you’ll get. Without that, you simply can’t know if you’re making the right decision.
401(k) Early withdrawal penalties
Whenever you take money out of any investment vehicle, there is a downside. When the government has a vested interest in your money being in said vehicle – getting more in taxes and having independent retirees – you can be sure there are some extra penalties to the action.
Surprisingly, there is only one formal penalty in the case of a 401(k) early withdrawal.
10% IRS penalty
A 10% extra tax is the only literal penalty from an early withdrawal. If your withdrawal does not meet any of the requirements for an emergency withdrawal or loan, there will be an extra 10% tax imposed on your withdrawal.
It is essential to understand that this rate is in addition to your original income tax. So, an early withdrawal of $10,000 will have an additional $1,000 of taxes due.
Standard income tax
Yes, any withdrawal, whether early or not, is considered income. Money put into a 401(k) is tax-deferred – unless you have a rare Roth 401(k) – and will be taxed when you take cash out.
Since an early withdrawal may mean that you’re taking this money while still working, this increases your taxable income and may push you into a higher tax bracket.
Depending on how long you’ve been with your company, all of your money may not be available to you. The vesting schedule refers to the amount of the employer’s contributions that you have a right to.
All contributions of your own money are always 100% vested, but employers have a right to require an amount of time with the company before you gain a right to their contributions. This means that you may not have the available funds that you think. If you are not 100% vested in your 401(k), the entire balance of your 401(k) is not yet yours.
401(k) Early withdrawal benefits
There are loopholes
If you have a genuine emergency, several exceptions allow you to use a 401(k) early withdrawal without any penalty at all. Some circumstances include first-time home purchase and medical emergencies. Even if you don’t fall into one of those categories, you might be able to use a 72t, which allows for a series of equal payments over several years.
Another option may be to take a loan from your 401(k), but not all company plans allow this.
Get money when you need it
The most apparent advantage is access to your money if you need it. Of course, it’s not all of the money that you might have had if you didn’t need to make an early withdrawal, but at least you have an opportunity to take care of whatever issues you needed the money for.
Better places for the money
You may come across an opportunity that would be a better place to use your money. For example, perhaps a fantastic real estate deal comes across your plate, and you need another $10,000 for closing costs. Paying that $1,000 penalty could very well be worth it in the long run if the deal is as good as you think (make sure of this before executing an early withdrawal).
What to make of a 401(k) early withdrawal
As is the case with most things, there are pros and cons to an early withdrawal. The simple solution is to do your homework and be certain of what you’re getting from withdrawing your money early and if it’s worth the penalty.
If you don’t do your due diligence, you can be almost sure you’re losing money somewhere. Remember, it always helps to consult a professional to cover all your bases.
Is a 401(k) your primary vehicle for retirement savings, or do you take another approach?