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

By Jay Shareef and Chris Rhoads

The ideal figure needed for retirement varies from person to person. Regardless of the number you need, the fastest way to grow your funds is to maximize your contributions and watch your money grow. Sometimes, though, unexpected life events pop up, and with those life events, unexpected costs can find us contemplating an early withdrawal from our 401(k) account. After all, it’s just sitting there. What harm could it really do? There are some disadvantages to an early withdrawal, so if you’re thinking about cashing out your 401(k) early, consider the following consequences and take time to research some 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. But just because others are doing it, keep in mind 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. 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. 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. 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.

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. So not only do you earn interest on your principal, but also on the interest you’ve already earned, so you’re earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. Many people lose sight of this critical point when they only look at their short-term financial situation.

Your money is earning money for itself just by 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 future pocketbook.

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. On top of that, he lives in California and faces a 9.3% state tax. 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. At WealthFlow Financial, we work closely with our clients to design retirement strategies that provide confidence and clarity while also helping to protect their future. Using customized strategies that are created through a true partnership, we empower our clients to weather the inevitable challenges that our complex financial world presents. If you don’t already have an advisor helping you do that, reach out to us at (301) 798-5250 or schedule a phone call now.

About Jay

Jay Shareef is vice president, financial advisor, federal benefits consultant, and co-founder at WealthFlow Financial. As a U.S. Army veteran, Jay is passionate about helping federal employees create a bulletproof plan for retirement and navigate the often confusing and complicated federal benefits landscape. He spends his days educating and providing clients with unbiased insurance benefits and retirement strategies to help his clients create guaranteed income for life. As a problem-solver and trustworthy resource, Jay always puts his clients and their needs first so they can find financial peace of mind. To learn more about Jay, connect with him on LinkedIn.

About Chris

Chris Rhoads is a co-founder and vice president of WealthFlow Financial. As a registered investment advisor and independent financial professional, Chris is committed to helping his clients in retirement and he takes a holistic approach to financial planning that includes insurance and risk management, investments and wealth management, retirement income planning, and estate and tax planning. Chris has been married to his wife, Tia, since 2009 and they live in Frederick, MD, together with their two young daughters. In his free time, Chris enjoys traveling, watching sports, and being active in causes about which he cares passionately. To learn more about Chris, connect with him on LinkedIn.

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